Succeeding in Your Business: What to look for in franchise documents (Part 1 of 2)

Cliff Ennico

“I was recently laid off from a corporate job and have decided not to return to corporate America. I’m thinking about buying a franchise, but their Franchise Disclosure Document (FDD) is over 100 pages long, and I really don’t know where to begin. Do you have any tips for reviewing FDDs, and the questions I should be asking these folks?”

Here are 10 things you should look for when{mprestriction ids="1,3"} reviewing a franchise’s FDD (the disclosure document franchises are required by law to deliver to prospective franchisees):

No. 1. How many other franchisees are there and how long have they been in business?

The first place to look is the number of franchisees. If there are relatively few, and the franchise has been in business only a couple of years, then this is an “early stage” franchise. There’s good news and bad news there.

The “good news” is that you might be able to buy “area development rights” to an entire state or region of the United States. This means you are the “master franchisor” for your state or region and can sell franchises to the local folks who will actually grill the hamburgers, dry clean the shirts or whatever. You can get filthy rich that way — all you have to do is collect the royalty checks from your franchisees, deduct your fee and remit the balance to the franchise headquarters. Not a bad way to make a living, no?

The “bad news” is that this franchise’s model hasn’t been tested yet. There’s a good chance this franchise will fail and you will lose your investment.

Unless your appetite for risk is unusually high, what you want to see is a fairly large number of franchisees who bought into the franchise at consistent intervals. (In other words, the number of new franchisees is fairly consistent from year to year.) Be careful before buying into a franchise if all of the franchisees have bought into the system within the last three years or all of the franchisees have been in place for more than three years and there are no “newbies.”

No. 2. Where are the franchisees located? Are they all over the country or concentrated in certain places?

Many franchises are “regional” in nature; they work well in some parts of the country, but not so well in others. For example, a franchise that serves smoothies and other healthy food products is bound to do well in California and college campus towns. Will it do as well in cold-climate states or rural areas? A franchise that originates in the Midwest and South — where real estate prices and labor costs are relatively low — may well have problems when it expands to the East Coast and West Coast.

No. 3. How many franchisees have left the system in the past few years?

A franchise is required to tell you the names, addresses and telephone numbers of franchisees who have left the system for one reason or another. The better ones disclose that information in their FDDs; the rest will tell you, but only if you ask. Call these folks and find out why the franchise didn’t work for them. Most of them will have an ax to grind, of course, but by listening carefully you should be able to determine if the problem was the franchise or if these people simply weren’t a good fit for the franchised business.

No. 4. Typically, how long does it take for a franchisee to recoup the initial upfront investment?

This information probably won’t be in the FDD, but by calling lots of franchisees (I always recommend talking to at least 10), you should be able to get a sense of roughly how long it will take for you to recover your upfront investment in the franchise. If it’s less than three years, great! If it’s more than five years on average, I would ask the franchise lots of tough questions.

No. 5. Has the franchise sued any of its franchisees, or vice versa? If so, what are these lawsuits about?

The “litigation” section of the FDD is probably the most valuable in the whole document and is often overlooked by prospective franchisees because “only a lawyer can understand this stuff.” Bad mistake! A franchise that sues its franchisees over relatively minor infractions of its rules is not a franchise you want to be involved with.

If a franchise is more than five years old and there are more than one or two lawsuits with franchisees, you need to ask some questions. If the franchisees were clearly in default and the franchise had to sue to recover its royalties and boot the “bad apples” out of the system, that’s one thing. If, however, the claims are for antitrust law violations and were brought by state attorneys general, that may indicate a fundamental problem with the franchise’s business model. Ask your attorney to review this section of the FDD (most will not charge more than an hour’s time for this) and explain the contents in plain English.

More next week.

Cliff Ennico (crennico@gmail.com) is a syndicated columnist, author and former host of the PBS television series “Money Hunt.”
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