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Scam Alert How do you spot a franchise scam?

Back before California started the move to regulate the offering of franchises during the 1960s, and long before the Federal Trade Commission published its franchise rule at the end of the 1970s, buying a franchise could be as risky as putting your 401(k) into Enron or Talk magazine. Before disclosure, the franchise industry suffered from companies that had lots of hype, little substance and an absence of management talent. What they did have were great salespeople.

Some of the franchise offerings back in the '50s, '60s and '70s were for companies that had never opened a single unit before selling franchises. Some had management that had never been in the business but did have experience in bankruptcies, litigation and problems with regulators. Some of the companies were so weak financially that they needed the proceeds from franchise sales to meet payroll or to pay for the franchise ads the prospects responded to. There were even stories of franchisors whose furniture was being repossessed in one room while the prospective franchisee was in the other. Just because the government regulates something, though, doesn't mean things are always better. While not common, there are still franchise offerings today that are such poor opportunities, they would have fit in nicely with the other bandits back then.

How is that possible? In part, due to the ease of developing a franchise system, the lack of consistency in franchise regulations and to the way franchises are sold. But the primary reason franchise scams still exist today is there are still individuals who don't do their homework, and end up investing in these "opportunities." They allow the bad opportunities to remain in business.

There's no single indicator of a franchise scam, and you need to weigh all the indicators in making your assessment. Just remember, hundreds of superior franchise opportunities are available today, and there's absolutely no reason to settle for less than the best opportunity in your investment range. There's little you can do about the ease of development or the inconsistency of regulations, but you can protect yourself by doing your homework.

The disclosure document is a wonderful tool for prospective franchisees to have. At your first personal meeting with a franchisor, that franchisor is required to provide you with one. Some franchisors will even mail you a disclosure document; others post them on their Web sites.

Even before you get to the point of contacting a franchisor, you can get a sense of whether their opportunity is for real. Go online and research news stories about the company and the industry. If the company is public, look at the information available from their SEC filings. Visit their Web site and get information about their consumer offering as well as their franchise offering. Learn what you can about their management and thoroughly research their background. Compare the company to its competition-both franchised and non-franchised. Locate some of their stores and speak to existing franchisees. Then, when you're satisfied, contact the company.

When you first contact the company, ask them about the process they use in selecting franchisees. If you get the sense that they don't select franchisees but are in the business of selling franchises, that's your first indication the franchise is risky.

Remember, a franchise system is only as strong as its brand, and that brand rests to a great extent on how well the other franchisees in the system perform. If the franchisor lets anyone who has money in the system and does not have selection criteria, then your investment will probably be at risk.

If the company is willing to "sell" you a franchise and doesn't require you to visit with them at their company headquarters so you can perform a thorough evaluation of them and they can perform a thorough evaluation of you, that's another sign of a poor franchise system. If the salesperson you're talking with isn't an employee but an outside sales broker, that's even a stronger indication. Remember, unless you buy the franchise, the broker doesn't earn any money. And, since he isn't an employee of the franchise system, he doesn't risk much more than the chance to earn a future commission check if he recruits franchisees destined for failure.

When you visit the franchisor's headquarters, meet as many of the franchise support people as you can. Assess whether they have the experience to do their jobs. Make sure they're required to provide you with the level of support you expect. Take a look at the condition of their offices. Do you get the feeling of success or impending doom? Do all the company's resources seem to go into marble and brass, or does the company seem to be investing in computers, personnel, training programs and other components of support?

Be prepared to thoroughly analyze your disclosure document. If you're still interested after you read the company's information, engage a qualified franchise attorney, consultant or accountant to help you in conducting your due diligence. Franchise salespeople or brokers work for the franchisor. No matter how friendly or professional they may be, you shouldn't rely solely on their advice.

The Red Flags

To determine whether a franchise is legitimate or a scam, answer the following questions:

Does the company have experience in the business being offered? I'm not talking about a related business, but the exact business. If the company has successfully been operating 4,000-square-foot stores, but the franchise opportunity is only for 1,000-square-foot stores, it's not the same business, no matter what they say. The same works in reverse-bigger is not always better. If you plan to open your franchises in Boston, but the only experience the company has is in Texas, it's not necessarily the same either. Have they done the necessary research to determine if the concept will work in Boston, or are you going to be their cold weather guinea pig?

Does management have a history of success? Does the franchise management know how to operate your business successfully? If not, what type of support are you likely to get? How frequently have they changed jobs? How well are their former companies doing? If they seem to move just before the sheriff or process server arrives, that's not a good sign. If they've worked with other franchisors, call franchisees of those systems and find out how well this management did in the past. A mix of executives with experience in the business and as successful franchisors is a great benefit to franchisees.

What is the financial condition of the company? Your investment will probably be significant. In some franchises, between debt and equity, your investment may exceed seven figures. Will you have more skin in the game than the franchisor does? Do they have a history of profitability? Are they earning their revenue from royalties and other continuing sources of revenue, or are they relying on the sale of the next franchise to make payroll? Even new franchisors need to have financial resources to meet their commitments.

Are you getting value for your money? Sure, if it's a well-known, established brand and the franchisees in the system are doing well, although this means you'll probably have to pay a sizeable franchise fee. But, if it's a new franchise system and your training lasts only a few days, are you paying more than it's worth? Paying $25,000 or more for a franchise fee when you're only getting one week of training from a new franchisor with limited experience, simply because they have a great brochure, doesn't make sense. Ask the other franchisees in the system if they got value for their money. Keep in mind, though, that franchisees new to the system may not even know yet.

What's the franchisor's litigation or regulatory history? Franchisors must disclose relevant litigation. Sometimes litigation is good. Any franchisor that enforces system standards will occasionally need to sue its franchisees. If they're able to still maintain a good relationship with their other franchisees, that type of litigation is an indication of a strong and responsible franchisor.

However, if there are pages upon pages of lawsuits from franchisees listed in the disclosure documents, that's not a good sign. You need to understand the basis for the lawsuits and make a decision based upon the facts. Your attorney can help you analyze the franchise litigation.

Is the franchise offered only in the non-registration states? Only 12 states review franchise documents and require franchisors to register their offering before getting permission to offer franchises in their state. In the rest of the United States, no regulator ever sees the franchise offering. Sometimes companies don't offer franchises in the registration states simply because those states don't fit into their geographic strategy. But, if a franchisor is offering franchises all over the United States except for the registration states, that may indicate their franchise wouldn't meet the requirements. Be very careful when you come upon opportunities that go out of their way to avoid the registration states. For more information as well as a complete list of franchise registration states, click here.

Finally, I have to admit some bias toward membership in the International Franchise Association, since I'm on the IFA's Board of Directors; was chairman of the professional arm of the association, the Supplier Forum, and have been active in the organization for more than 15 years. While active membership in the IFA doesn't guarantee a franchisor is a worthwhile investment, it's a strong indicator of a responsible franchise system. Active IFA members have access to training programs, networking opportunities and meetings in which they can exchange best practices with other franchisors.

These are just a few of the questions you need to assess in determining whether the franchise you're interested in is a scam. Your outside advisors can help you put aside your entrepreneurial eagnerness to get into the game and assist you in conducting a proper due diligence. Don't get into a franchise unless you have the assistance of a qualified expert. The franchise salesperson who has befriended you has the advantage of having been through the selling process hundreds of times. This is likely to be your first experience.

Michael H. Seid is managing director of Michael H. Seid & Associates, a West Hartford, Connecticut- and Troy, Michigan-based management consulting firm specializing in the franchise industry. Seid recently co-wroteFranchising for Dummies(IDG Books) with Wendy's founder, the late Dave Thomas.

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