A Closer Look An expert reveals the secrets to investigating a franchise.

There are two faces of franchising. One face offers theglittering smile of enormous financial rewards and conjures upvisions of Ray Kroc (McDonald's) and Colonel Sanders (KFC) andthe thousands of millionaires they've helped into business.These pioneers made franchising a household term with their motto:"Get in early, build multiple stores fast and make amillion."

The other face is the darker side of the franchising story. Theearly years of franchising growth culminated in a "60Minutes" TV report titled "From Burgers toBankruptcy," which aired in December 1978. The show told thestory of a couple of slick guys in rented Rolls-Royce automobilesand gaudy jewelry who sold the empty promise of phony fast-foodsuccess on the strength of their outrageous claims of instantwealth. The motto of this face of franchising: "Fast-buckartists selling hot air on the promise of success."

Understanding the dual nature of franchising is an essentialstep in the task of finding the right investment for your interestsand resources. Go to a franchise trade show, and notice the pace ofthe sale. It's fast. It's a hard sell. And, all too often,it is accompanied by exaggerated claims of earnings potential. Theother face of franchising can be difficult to uncover, but there isgood news: The law is on your side, and you will be prepared forthe process if you do your homework and bring diligence to yourtask.

Andrew A. Caffey is a practicing attorney in the Washington,DC, area, a former General Counsel of the International FranchiseAssociation, and an internationally recognized specialist infranchise and business opportunity law.

The Informed Investor

Since the 1970s, a number of states and the Federal TradeCommission (FTC) have seen to it that burgers don't lead tobankruptcy, at least not because the expensive cars are rented andthe dazzling jewelry is fake. Every franchise buyer in the UnitedStates is protected by the receipt of a comprehensive disclosureprospectus, dubbed the Uniform Franchise Offering Circular (UFOC),at least 10 days before the purchasing commitment is made.

The UFOC contains a mind-boggling amount of information aboutthe franchisor, its key people, its litigation and bankruptcyhistory, the fees to be paid to the company, the total investment,purchasing restrictions, basic information about trademarks, thekey terms of the franchise agreement, the addresses of franchiseowners, a list of franchisees who have left the system, and more.Attached to the document are copies of all contracts to be signedby the franchisee as well as the franchisor's audited financialstatements. Armed with this key information, the investor will bein a position to make an informed decision about the franchise. Atleast in theory, the true face of the franchise will berevealed.

Doing Your Part

It would be easy if receiving the UFOC was the end of the effortto protect yourself, but it's not. An additional effort must bemade to be sure the franchise you're considering doesn'thave a darker side.

How can you protect yourself? Take these five steps to successin choosing a franchise:

1. Research the market. Before you jump into theidea of franchising, carefully research the business potential ofthe town where you plan to locate. Start by driving around andobserving where the growth is in your community, where newbusinesses are being built and what businesses are clearlyprospering. Head to the library, and check the statistics relatingto the town's business growth. Skip this vital step, and youwill be flying blind-and vulnerable-once you begin the process ofevaluating franchise opportunities.

2. Read the UFOC. The disclosure document is vitalto your investigation, but it is little more than a paperweight ifyou don't read it.

The UFOC recently underwent a renovation. The new-format UFOC,after a two-year phase-in period, becomes mandatory for allfranchisors as of January 1. Much improved over the previousformat, which had been used for more than 20 years, the "newand improved" UFOC is written in plain English and isconsiderably shorter than it used to be.

The first parts of the UFOC contain a general description of thefranchisor, a list of the people running the company and generalinformation about the franchise offering. Here you will findlitigation and bankruptcy history if there is any to reveal.

Items 5 through 7 detail information about the initial andcontinuing fees to be paid to the franchisor and the company'sestimate of your total investment in the franchised business.

Later sections summarize purchasing restrictions, discussfinancing available from the company, and spell out the servicesthe franchisor promises to provide to you. You'll find keyinformation about any relevant trademarks, patents or copyrights,and whether you are required to be personally involved in thebusiness's management.

If the franchisor provides information about earnings amongfranchisees in the system, it will appear in Item 19. Franchisorsare not required to give potential franchisees earningsinformation, but if they do, the law requires them to put it inwriting in the disclosure document.

Item 20 contains your best leads for further research-the listof current franchise owners and those who have left the system inthe past year. Take advantage of the list, and select a randomsampling to contact.

Attached to the UFOC are two essential documents. First,franchisors must include up to three years of audited financialstatements. An audited statement means an independent CPA hascertified that the statements were prepared according to theindustry standard Generally Accepted Accounting Principles.

You are planning to make a major investment that could last for20 years or more, so do not pass "Go" without anindependent evaluation of the company's financial standing.Read the statement carefully; if you are at all uncertain about howto read it, seek out a competent accountant.

The other attachment is a sample copy of the standard franchiseagreement and any related contracts you will sign with thefranchisor. Unlike the UFOC, the typical franchise agreement is notwritten in plain English and is often difficult to read and fullyunderstand, so proceed with caution. Best approach: Find a goodlawyer who can review the contracts, discuss them with you andanswer your questions.

3. Talk to franchisees. Who else is closer to thereal story? The biggest mistake you can make is to let the sellerhandpick a few franchise owners for you to interview-by phone.Instead, take the list in Item 20, and do your own research-inperson. Get in the car, and visit the franchisees you have pickedfrom the list. Watch their businesses in operation, do a roughcustomer count, and quietly confirm to yourself that you wouldenjoy working in this business.

Here are some key questions to pose to the owners you visit:

• Knowing what you know now, would you buy this franchiseagain?
• What is the toughest and what's the most pleasant part ofthis business?
• How was the quality of the franchisor's training program?Did you feel well equipped to start the business?
• What were your gross sales last year? What was your pretax net?Is the franchise living up to your financial expectations?
• Does the franchisor provide useful assistance when you haveproblems? Is it responsive and prompt?
• Did you have enough money to capitalize your start-up? Are thecompany's estimates of the total investment in Item 7realistic?

Complete your research by tracking down a few franchisees wholeft the system in the past year. Find out why they left and howthe franchisor handled their departure. Was there a dispute?Litigation? Did the company have effective dispute resolution(arbitration, mediation or other) programs in place to head off anylegal dispute?

4. Throw some really tough questions at theseller. Be prepared to ask the franchisor'srepresentatives many of the same questions you ask thefranchisees-and then some. Put a few of these in your notebook:

For companies with no earnings claim in Item 19: Why is there noearnings information listed in the UFOC? Is it because the numbersare not very attractive?

For companies with an earnings claim in Item 19: Can you provideany more specific earnings information about other franchisees inmy market? (The law allows a franchisor to provide such"Supplemental Earnings Information" outside of the UFOC.For instance, if you find in Item 19 a statement of the nationalaverage gross sales of the franchisees in the system, the companycan lawfully tell you the gross sales of franchises in the townwhere you will be starting. Press for this information; it could beextremely useful.)

• What is the main reason franchise owners fail at thisbusiness?
• Tell me about the culture of your franchise system. What isyour philosophy regarding the franchise relationship?
• What are the company's plans for franchise expansion?
• What procedures are in place for resolving disputes between thecompany and its franchisees?
• Is there a franchise owners' council or association? Whatrole does it play in the company's decision-making?

5. Get professional help. This is no time to pinchpennies on good advice. You are considering entering into a complexlegal relationship, complete with all the financial challengessmall-business ownership can throw at you. Find an experiencedattorney familiar with franchising and representing small-businessowners, and pay for a review of the UFOC. Be sure you understandthe franchise agreement and the other contracts that accompanyit.

You may also want to seek the assistance of an experiencedaccountant to help you put together your numbers. Like everyentrepreneur planning to start a business, you need to develop adetailed business plan in which you project your revenues andexpenses. You cannot afford to wing it.

Franchising adds a unique dimension to your efforts to start abusiness. And finding the right franchise requires a lot of hardwork-doing independent research, interviewing other owners andcarefully evaluating complex legal documents. Like it or not, thereis no other way to see past the two faces of franchising.

Watch Your Step

As you investigate franchises, be sure to avoid these commonmistakes franchise buyers make:

1. Losing sight of what you want. You're looking fora part-time, homebased business, but you end up with a fast-foodoperation that demands 90-hour workweeks. What happened?

It's easy to lose sight of your original goals when hit withthe franchise hard sell. Know what you want before you go shopping,and avoid franchises that don't meet your criteria.

2. Getting in over your head financially. Franchises areexpensive. There are upfront fees, equipment and training costs,royalties and more.

As with any business, know how much you can afford to spend onstart-up. Write out a business plan showing financial projections,and stick to it.

3. Not getting feedback. It's easy to feel isolatedwhen buying a franchise, but you can end up making a big mistake ifyou don't get outside advice.

Seek people who can help you evaluate a company objectively.Visit existing franchisees, as well as some who have left thesystem. Ask them what they like and don't like about thefranchise.

4. Failing to read the fine print. Yes, the UniformFranchise Offering Circular (UFOC) is a hefty and intimidatingdocument. But you are making a sizable investment that will affectyour daily life for years to come. You can't afford to ignoreany information that will help you make the right decision.

It's essential to read the UFOC and related documentscarefully. Bonus: This year, all franchisors are required to usethe new format, "plain English" UFOC, which is far easierto read than the old format's mind-boggling legalese.

5. Being penny-wise and pound-foolish. Paying to have aqualified lawyer and accountant read the UFOC with a fine-toothedcomb is an investment well worth making. Scrimping on professionalfees now could cost you thousands later.

6. Buying in too early. Buying into a new franchisesystem can be a great way to get in on the ground floor.Unfortunately, some new franchisors haven't yet worked out allthe bugs; moreover, they may not have the name recognitionthat's such an important part of the franchise formula.

Move extra cautiously if you are considering a new franchise.Meet other franchisees if there are any, and pay particularattention to founders' previous business experience. One plus:It may be easier to negotiate flexible terms when dealing with anew company.

7. Falling for exaggerated earnings claims. If thefranchisor's claims of profit potential sound too good to betrue, they probably are. Take any such claims with a grain ofsalt.

By law, any earnings claims a franchisor makes must be backed byhard data. Again, talking to franchisees will give you a bettersense of the validity of these claims.

8. Not checking the warranty. For whatever reason, thefranchise doesn't work out as you'd hoped. Now what do youdo?

Know your options before you buy. The franchise agreement willspecify your alternatives for getting out of a franchise. Reviewthem carefully with your lawyer before signing on the dottedline.

For More Information . . .

• The Federal Trade Commission (FTC) provides a package ofinformation about the FTC Franchise and Business Opportunity Rulefree of charge. Contact Public Reference Branch, Federal TradeCommission, Washington, DC 20580, (202) 326-3128.

• The American Business Opportunity Institute Inc., anational information clearinghouse and seminar company specializingin business opportunity and franchise investment and regulation,provides publications, programs and services. For information, senda self-addressed, stamped business-sized envelope to AmericanBusiness Opportunity Institute Inc., c/o Andrew A. Caffey, # 700, 3Bethesda Metro Center, Bethesda, MD 20814.