Navigate the Paper Trail
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:
- Interviews with the franchisor
- Interviews with existing franchisees
- Examination of the Franchise Disclosure Document (FDD)
- Examination of the franchise agreement
- Examination of the audited financial statements
- An earnings-claim statement or sample unit income (profit-and-loss) statement
- Trade-area surveys
- List of current franchisees
- Newspaper or magazine articles about the franchise
- A list of the franchisor's current assets and liabilities
Through this research, you want to find out the following:
- If the franchisor as well as the current franchisees are profitable
- How well-organized the franchise is
- If it has national adaptability
- Whether it has good public acceptance
- What its unique selling proposition is
- How good the financial controls of the business are
- If the franchise is credible
- What kind of exposure the franchise has received and the public's reaction to it
- If the cash requirements are reasonable
- What the integrity and commitment of the franchisor are
- If the franchisor has a monitoring system
- Which goods are proprietary and must be purchased from the franchisor
- What the success ratio is in the industry
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 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:
- Item 2 describes the business background of the officers, directors and managers of the franchise company. Scan these summaries to get an idea of their experience.
- Item 3 summarizes the litigation background of the franchisor and the people listed in Item 2. If there have been actions taken by state or federal enforcement agencies, or if private lawsuits relevant to the franchise system have been filed against the franchisor in the past 10 years, they are summarized in this section. If you find a significant number of actions, especially where franchisees have sued the company, make a note to investigate further.
- Item 4 lists any bankruptcies in the backgrounds of either the franchisor or the people listed in Item 2.
- Items 5 and 6 summarize the initial franchise fees, ongoing royalty fees and other charges franchisees must pay. If the initial fees have been negotiated in the past year, that will be disclosed in Item 5.
- Item 7 presents the franchisor's estimate of the typical total investment by the franchisee, in chart form. You will need this key information when you prepare your own business plan or seek financing for the franchise. Be sure you review this information with your accountant.
- Item 8 discloses the restrictions placed on the franchisee's purchase of supplies and product inventory for resale in the franchised business. It also presents information about rebates generated by franchisee purchases and the portion of the franchisor's revenue that comes from purchases made from the franchise company. If it looks like most of the franchisor's revenue comes from franchisee purchases, find out from other franchisees if products are fairly priced and effectively delivered. Supply arrangements are a vital aspect of running a franchise, so make sure the system works well.
- Item 10 discusses financing. Many franchisors either provide financing to franchisees or make special arrangements with banks or other lenders to assist franchisees. Even if there is no mention of special financing arrangements in this item, ask the franchisor about them.
- Item 11 , the longest section in the document, highlights the franchisor's obligations to the franchisee under the franchise agreement. It also describes required computer equipment purchases and the initial training program.
- Item 12 explains territorial rights. Make sure you understand exactly what rights you have, both inside and outside any designated territory. If the franchisor reserves the right in this item to distribute competing products or services through other channels of distribution, find out what this means and how the company intends to use that right.
- Item 13 reveals details about the trademark licensed to franchisees. Is it federally registered or is registration pending? If it isn't effectively registered, the franchisor--and you--may have problems with it down the road.
- Item 19 reveals earnings claims. This key section shows what kinds of sales or profits other franchise owners have made, if the franchisor chooses to supply the information. Most don't. If a franchisor does provide this information, it must also provide data to prove the claims upon your request. If no performance information appears here, find out why. It may be because the performance of franchisees does not paint a very attractive picture, or it could simply be that earnings vary widely from one region to another or one franchisee to another. Ask franchisees about their sales and profits; most are happy to share their experiences.
- Item 20 contains systemwide statistical information, such as how many new businesses have opened over the past three years and how many franchise owners have left the system over the same period of time. This section also contains a list of the names, addresses and telephone numbers of current franchisees and those who have left the system in the past year. Call them.
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:
- Sign requirements. This is generally outlined in the franchise agreement in the proprietary market section: what your use of the sign must be, may be and may not be.
- Training and advisory assistance. There's usually a section that outlines what training and assistance you're going to get. The agreement will indicate that you must complete a training program and that the company must give you assistance in starting out and in training you. Franchisors will indicate that they'll provide you with an ongoing advisory service and promotional materials, bulletins and marketing development products and techniques.
- Advertising. Generally, franchisors will want to approve all advertising copy and packaging and promotional materials that you use to ensure that they're consistent with the concept. Companies may establish a national advertising fund to which you'll have to contribute and of which you'll be a beneficiary during any national advertising campaigns. They may require you to spend a certain amount of your gross income on local advertising.
- Operating manual. Franchisors will require that you follow the operating manual, that it be kept confidential, that it's a property of the franchisor, and that you must adopt revisions to the manual, which will be made by the franchisor on an ongoing basis. Companies are very concerned about this operating manual because it tells everything about their businesses.
- Maintenance and repairs. The franchisor will want you to maintain the interior and exterior of your location. They want the ability to force you to repair your unit in five or 10 years so that you don't allow it to get run down. In some cases, there are franchisor provisions that require the franchise to construct additional buildings if the franchisor feels they're necessary in order to accommodate the business. Generally, these provisions have not been accepted very well by most states.
- Accounting and records provisions. These provisions will require you to keep certain records including weekly sales reports, semimonthly sales reports and monthly profit and loss sales reports. Franchisors will want to be able to inspect your records through their area supervisors or representatives to ascertain that you're correctly reporting the activity of your business, making sure you're not understating your sales to cheat them out of royalties. There will also be a section requiring you to give them annual, audited statements by a certified public accountant.
- Standards and quality. These provisions will establish uniformity, and will provide for purchases, which conform to the franchisor's specifications. These sections are in some cases quite extensive.
- Quality control provisions. The more labor-intensive your operation, the more franchisors will insist on certain procedures. If you're handling a franchise which simply dispenses a pre-made product, there isn't as great a concern on the part of the franchisor, but in cases where a product is labor-intensive and made on the premises, whether it be food or manufactured items, the quality-control provisions will generally be very substantial. This is for your benefit as a franchisee as much as it is for the franchisor's.
- System modifications. Specifically, this section will establish the right of the franchisor to modify the concept, but it will also prohibit you as a franchisee from any unauthorized modification of that system. In other words, franchisors want the system to be uniform and don't want you to change anything without their approval. When they want a change, they want the power to say you must change the procedure.
- Continuing services and royalty fee. These provisions establish that you'll be paying a royalty--an ongoing percentage of sales, or a fixed monthly or annual amount which will be remunerated to the franchisor for the continued use of the franchised concept. The franchisor will determine what kind of program is necessary, as well as what kind of support will be provided on an ongoing basis. The direct and indirect costs associated with those services are projected, and a percentage is established to cover those expenses. The method in which the franchisor collects and assesses these fees is provided for in the franchise agreement.
- Insurance provisions. The franchisor knows what kind of insurance and liability protection you need, as well as what kind of protection they need. The agreement will generally establish what amounts will be required for protection including workman's compensation, general liability, product liability, bodily injury and property damage.
- The terms. How long will your franchise agreement be in effect, and what are the options beyond that period of time? The term clauses are generally coordinated with the lease so that if you have a lease for 15 years, you'll have a 15-year franchise agreement. A long-term agreement assures the franchisor that it will receive a royalty for a longer period of time, and it gives the franchisee more security. A shorter term gives the franchisor the ability to adjust the royalty upward more quickly, and it eliminates undesirable franchisees. When their term expires, they're simply not renewed.
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.
- Covenant sections. These restrict a franchisee from copying or diverting business, hiring employees or divulging secrets. These restrictive covenants are subject to state or antitrust laws. Some states won't allow restrictive covenant sections while others will. Some antitrust laws prohibit certain restrictions of a person's ability to earn a living. Franchisors will indicate that you as a franchisee cannot simply open an identical business, using all the franchisor's systems and know-how and marketing tools and so on, without using the franchise name and paying a royalty.
- Termination and defaults. This section provides the terms under which the franchisor is able to terminate you or to say you're in default. If you become bankrupt, for example, that is usually a condition allowing for termination of the franchise agreement. If the franchisor gives you notice to cure a certain defect, you'll have a limited amount of time to comply.
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.
- Taxes and permits. This clause will require the payment of any tax assessments, liens, equipment or previous accounts, and that you be in full compliance with all federal, state and local laws. This protects the franchisor as well as you. It will require that you obtain all permits, certificates and licenses necessary to do business at that particular location. The agreement will provide that you're an independent contractor; that you're not an agent, partner or employee of the franchisor; that you can't incur any liability for the franchisor; and that you bear the cost of defense of any claims. Generally this section clarifies that any debts you incur are your own and not the franchisor's.
- Nonwaiver provision. This says that if the franchisor doesn't enforce a certain clause in the franchise, that doesn't mean it isn't enforceable at a later date. There's usually a similar provision on the receipt of payments. If franchisors don't accept a payment from you, that doesn't mean they don't have the right to come back and collect it later. There's also a notice provision that dictates the manner of notice, how much notice they have to give you, how it should be served, to whom and where. Provisions for liability for breach, which involves payment or costs for attorneys' fees by the party in default, are also sometimes put into an agreement.
- Arbitration clauses. Some states won't allow them and won't recognize them, but they do provide a basis for settling disputes without having to go to litigation. They sometimes provide for binding arbitration. Both the franchisor and franchisee provide an arbitrator, then these two pick a third arbitrator. The third arbitrator may do the arbitration, or all three of them might. They listen to the issues, the company's side and your side. With binding arbitration, whatever the arbitrators decide will dictate the final agreement.
- "Franchisee" definition. This definition will include not only you, but also any successors. There will be a caveat, which is a disclaimer, to any claims made. It indicates that you agree you're assuming certain risks, that the success of the business isn't guaranteed, and that the success of this business depends on your ability at a franchisee.
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.
Continue on to the next section of our Franchise How-To >> Conduct Interviews