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A Franchise for the Long Haul Before you invest, make sure your franchisor is financially stable.

Q: I am thinking about buying a franchise, and there are several franchisors to choose from. How do I tell if a franchisor is financially stable and able to meet its commitments?

A: One of the dangers of investing in a franchise is getting caught up in the hype--the sizzle of the opportunity. You simply need to step back and spend the time looking to see if there is any steak. There are probably no more important questions to ask than whether a franchisor has the financial ability and a track record of meeting its commitment to its franchisees.

Understand the franchise sales process. Great franchise salespeople can make you feel like there is an urgency to buy. The best of breed can make you feel reluctant to ask the hard and important questions--even while they are creating the illusion of pressuring you to do just that. The process calls for you to provide reams of information on yourself but doesn't always get your questions answered in depth. Sometimes you find that the person working with you doesn't even work for the franchisor you are interested in. They're brokers, and the amount you have to spend, the speed at which you are willing to spend it and the size of the commission check they get from the franchisor are more important than how good that investment is for you.

Finding out about a franchisor's financial capabilities is not a complicated process, but it often requires some investigation outside of the disclosure documents they provide you. Begin by examining the financial statements provided in the Uniform Franchise Offering Circular, item 21. Franchisors are required to provide their audited financial statements for the past three years or for a shorter period if the company has not been in business that long. Find out:

  • Does the franchisor have a history of profitable operations?
  • Does its balance sheet reflect a company that has financial stability?

Is it sufficient that they are making money? It's certainly a good sign, but that's not enough. Many franchisors do not disclose the sources of their income, and, depending on how long they have been in business and the size of their franchise system, the answer to that question can be critical.

When franchise systems are new, they often rely to a great extent on the initial franchise fees they collect from franchisees. That's understandable, because the system is growing, and there are not a lot of franchisees yet open. But as the franchise system matures, more and more of its daily operating income needs to come from more sustainable sources--the continuing royalties paid by its franchisees. No matter how profitable a franchisor is, if it is relying on initial fees to support the system--and franchise sales slow or stop--the franchise system is going to be in jeopardy, and that will impact franchisees.

While some franchisors may provide a detailed breakdown of revenue, others that do not may provide you with a supplemental disclosure of this information if you ask. Sometimes if the information is not broken down in the income statement, it may be contained in notes to the financial statements. Often, though, you will have to estimate initial fee revenue based on clues in the disclosure document that may simply be multiplying the initial franchise fee times the number of new franchises in the system. Remember, that is not an exact science because area fees, deferrals, etc. will impact your calculation. However, by making your analysis over a few years, you will begin to get an understanding of where the system is deriving its income and how much of that income is coming from continuing sources. Your accountant and attorney will be able to help you pull the clues out of the documents.

It is exciting to be part of a growing system. The brand recognition is improved, buying power increases, and it just seems that customers have an easier time finding you. But growth can be a double-edged sword if the franchisor is placing too much of its resources into growing internationally or if domestic growth is not in areas that benefit you. If resources are placed into growing the system and little is left over for research and development, system improvements, headquarters and field support, you are going to have problems since system growth won't provide you with much, if any, benefit.

Look at the trade literature for the industry the franchisor is in. If the company is public, look at its SEC filings. And don't forget the folks who are already in the trenches--the existing franchisees. They are the most knowledgeable people, as they experience the franchisor on a day-to-day basis.

It's your responsibility to do your homework on any investment opportunity. The great thing about franchising is that much of the information is readily available and can be easily verified.

Michael H. Seid, founder and managing director of franchise advisory firm Michael H. Seid & Associates, has more than 20 years' experience as a senior operations and financial executive and a consultant for franchise, retail, restaurant and service companies. He is co-author of the bookFranchising for Dummiesand a former member of the International Franchise Association's Board of Directors and Executive Committee.
Kay Marie Ainsley, managing director of Michael H. Seid & Associates, consults with companies on the appropriateness of franchising; assists franchisors with systems, manuals and training programs; and is a frequent speaker and author of numerous articles on franchising.

The opinions expressed in this column are those of the author, not of Entrepreneur.com. All answers are intended to be general in nature, without regard to specific geographical areas or circumstances, and should only be relied upon after consulting an appropriate expert, such as an attorney or accountant.

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