Due Diligence Steps for Prospective Franchise Investors
By Joseph S. Heino
While owning a franchise can be rewarding and profitable, many prospective franchisees overlook the fact that their new business venture comes equipped with a permanent supervisor – the franchisor. Thought you would be running your own show? Think again. Before you enter the world of franchising, it is best to conduct a thorough due diligence process to ensure that your new “boss” will be a good fit.
A good start is to talk to other franchisees to determine how the franchisor operates and how supportive it is of its franchisees. Talking to franchisees from a number of different franchise organizations will assist in making those determinations. It will also assist in gaining perspective as to what the level of name recognition is in the marketplace for each such organization. After all, the essence of all franchise law is the value given to the trademarks and service marks owned or licensed by the franchisor – name recognition is critical to the success of your business. Talking to other franchisees will assist you in determining if the franchisor’s “image” is one that you will want to project.
Another prerequisite is to ask the franchisor to provide you with a copy of its franchise “disclosure document,” formerly called the franchise “offering circular.” The franchise disclosure document, or FDD, is required to be provided to a prospective franchisee under the guidelines of the Federal Trade Commission and may need to be filed in certain states that require franchisors to register them. A total of 15 states have laws requiring disclosure and 12 of those require the franchisor to register or file the FDD with a state agency. Registration states include: Wisconsin, Illinois, Indiana, Michigan and Minnesota.
The FDD, though extensive in its disclosures about the franchised business and its owners, is only the beginning of the due diligence process. It should not be considered to be the answer to all questions that you, as a franchisee, will have. But the FDD is a great start, particularly because FDDs are required to follow a particular format. This means that information that is relevant to one franchise opportunity is easily compared with the same information for another franchise opportunity. In particular, the FDD will contain a list of other franchisees. This is the list that provides the starting point for contacting existing franchisees as mentioned above.
The FDD will also include a copy of the form Franchise Agreement that is used with the franchise opportunity. This Agreement should be reviewed by a lawyer so that relevant provisions such as royalty rates, royalty payment schedules, late payment charges, contributions to advertising funds, and rights and obligations of termination are clearly understood. In fact, the prospective franchisee is required to acknowledge that he or she has read the FDD, including the Agreement, and that its contents are understood. This can cause problems later on where the new franchisee later claims that an important term or condition was not understood.
The FDD is also a good resource of financial information about the franchisor. This information typically includes audited financial statements for the three years prior to the effective date of the FDD. These statements should be reviewed by an accountant for interpretation and guidance concerning the financial well-being of the franchisor. They provide an indicator of whether or not the prospective franchisee’s total proposed investment is excessive. The franchisee will need to consider the level of initial franchise fee to be paid as well as other investments including the costs of premises, equipment, inventory, security deposits, insurance payments, licenses, grand opening expenses and the necessary working capital to keep the franchised business going until it reaches a financial break-even point.
These are merely a few of the considerations that should be given when evaluating a franchise opportunity. Owning and operating a franchised business can be a satisfying and worthwhile endeavor, but choosing the correct business opportunity for you is critical to the success of that business. Do your homework. Most importantly, if there are any questions or doubts concerning any business opportunity that you are considering, you need to address them prior to signing on the dotted line of the Franchise Agreement.
Please contact your Davis & Kuelthau, s.c. attorney, the author noted above or the related practice group chair linked here if you have any questions.