Use This Checklist to Avoid Buying a 'Zombie' Franchise Here are 20 questions that will save you time and money. There are great franchise options out there, but you must do your due diligence.
Beware the zombie franchise.
It's the one that has stalled out, but still markets its opportunities as if nothing is wrong. Its brand relevance is typically shrinking; the number of open units is wilting. Previously loyal customers are being siphoned off by more innovative concepts. Underlying demographics may have shifted. Market trends could be working against the brand, yet management hasn't created a new path — and that managerial inertia or denial may be compounding the brand's problems. Unit-level economics are weakening, and an undercurrent of franchisee discontent is scaring away new franchise buyers and lowering franchise resale interest. Many existing franchisees would like to get out, if only they could — and expansion-minded franchisees look beyond the brand for better options.
From the outside, the zombie franchise may seem alive, but it's really dead.
New franchisees who miss those signals eventually realize their mistake. They may feel disclosures were inadequate or misleading. They often look back on conversations with franchisees and wonder how they didn't hear the negative feedback. They may remember sunny conversations with consultants, brokers, and the corporate team and feel duped. Or perhaps corporate is truly out of touch and doesn't even realize there is a problem! And if they do realize, often these brands spend significant money on branding and advertising to try to convince potential franchisees that they are still worthy of investment. They try to reinvigorate franchise unit sales, but not the underlying business. All the while, franchisee trust gets destroyed.
And so franchisees get trapped. Those inside a zombie system are typically shackled to the business with personal guarantees, a site lease, equipment or vehicle leases, a Small Business Administration loan, a loan against their home, a loan against their investments or 401(k), or loans from family and friends. The long-suffering franchisee can't hire enough help, because they can't afford it — yet they also can't sell the business or close it down. They are stuck.
But you? You're too smart to get pulled into a zombie franchise — and now you've got this easy checklist to keep your due diligence on track and avoid a weak franchise concept! Even if you're a founder hoping to sell to private equity, they will screen out brands with these attributes unless they are dedicated turnaround investors. So at the end of the day, no matter who you are, spotting these signs is really up to you. Here's what to look out for.
- A lack of unit growth, especially when it comes to existing franchisees. Talk to as many franchisees as possible. If they don't want to expand even though the territory is available, move on.
- Weak unit-level profitability. How will you grow if the units are struggling?
- Unfulfilled development agreements. If franchisees would rather lose their deposits than follow through and open promised units, that's a bad sign. Item 20 in the Franchise Disclosure Document lists franchisees and holders of development agreements. Connect with those franchises.
- The corporate parent is overly dependent on selling franchises. Look at how much revenue is related to franchise fees compared to recurring royalty revenues. Strong royalties are an indicator that their franchisees are doing good business.
- The corporate parent's priorities are wrong. If it's putting more attention on the supply chain and rebates to drive revenue, this is usually a signal of falling recurring royalties. If disclosures about rebates and supply chain costs to franchisees are murky, consider other concepts instead.
- Weak unit openings. In particular, look for a bloated sold-not-open (SNO) funnel or SNO numbers that are quietly adjusted from year to year. Google press releases and industry articles from prior years. Was management bragging about 400 units sold five years ago but now only 50 units are open, and the rest are still sitting in the Item 20 SNO list? That's a red flag.
- An increasing number of poorly performing franchises. Track down old disclosures so you can compare several years of unit-level performance. How resilient is the concept? Are the trends positive?
- Curious data disappearance. The franchise stops publishing Item 19 earnings representations when Item 19 was routinely included in prior disclosures.
- Increased franchisee litigation. No explanation necessary.
- Fleeing franchisees. Look for franchisees who want to sell before the expiration of their first license agreement.
- Disappearing franchisees. These are prospective franchisees who drop out after considering resale options.
- Franchisee discontent spilling onto websites dedicated to publishing stories from unhappy franchisees.
- Overly creative franchisees. During validation, these franchisees will tell you that they aren't following the system but have instead developed "hacks" to improve profitability.
- Poor franchisee validation, poor franchisee surveys, or other signals of a dysfunctional franchisee-franchisor relationship.
- A shrinking candidate funnel. Oh no.
- Weakening customer interest and/or a falling market share.
- Corporate team turnover, especially among field support, since they're the ones working most closely with potentially unhappy franchisees. Do franchisees provide positive grades on management team performance?
- 18. Management in denial of danger signs. Are they complacent? Blaming franchisees? Has anyone from the corporate team ever left to become a franchisee themselves? Why not?
- A lack of evidence of ongoing investment in innovation to keep the brand relevant. Do franchisees say this is a problem?
- Relatively high Small Business Administration loan charge-offs. These indicators may not appear right away, but they are certainly a troubling signal.
If you follow that list, it will save you time, money, and headaches. If you see weak signals, just move on. Be picky and protective of your assets. Only the worthiest concepts deserve your attention and commitment.
It's not just potential franchisees who should use that list, either. If you're a franchisor and you see signals that your brand is becoming the walking dead, start with improving unit-level economics and rebuilding trust and strong communication with your franchisees. If you're interested in eventually selling your franchise business to private equity, preventing problems is key. Any whiff of trouble can have a big impact on your deal terms, business valuation, and even which investors will take a serious interest in your brand. Once you've stalled out, it'll take more to prove you're back on track. Most private investors in franchising want a growth story, not to revive something struggling to survive.
No matter what situation you're in, use your brains — don't eat them.