Investigating Franchise Offerings

An initial step in reviewing a franchise is to obtain the franchisor’s offering circular. This document is now called a Franchise Disclosure Document. Under the FTC’s Franchise Rule, you should receive the document at least ten business days before you are asked to sign any contract or pay any money to the franchisor. During this time you should read the disclosure document and try to understand it. The following overview may help you to understand key provisions of typical disclosure but you should consider consulting with an experienced franchise attorney to assist you.

Business Background

The disclosure describes the prior business experience of the franchisor management. A franchisor which lacks business management experience may raise concerns.

Litigation

This disclosure of relevant lawsuits allows you to evaluate the franchisor and its management. The disclosure should tell you if the franchisor, or any of its management, have been involved in certain lawsuits or are subject to any court injunctions involving misconduct. Such claims against the franchisor may signal that the franchisor has not performed its agreements or has engaged in misconduct.

Bankruptcy

This disclosure should set forth if the franchisor, or any of its management, have recently filed for bankruptcy. This information can help you consider the franchisor’s financial stability and the general business skill of the management team.

Costs to Open

This disclosure sets forth the estimated costs to open a franchise. These costs usually start with an initial deposit, or franchise fees, and are sometimes expressly provided as nonrefundable. Other costs include inventory equipment, leases, and build-out expenses. A business advisor or accountant can help you evaluate this information.

Mandated Operations

Most franchisors restrict how you operate your business and often require compliance with an operations manual for which the franchisor reserves the right to make changes. These contract provisions may require:

Suppliers from which you must purchase products;
Goods or services you must offer for sale; and
The territory in which you can operate and advertise your business.

These restrictions may substantially limit your ability to make your own decisions and to make changes in operating your business to make it profitable.

Terminations, Assignment and Renewals

Most franchise agreements contain many, many reasons for which your franchisor may terminate your business. Franchise agreements also typically provide multiple duties for you after termination. Franchise agreements detail when and under what terms you can sell your franchise to others. The term and the renewal of the franchise agreement are also often covered in detail in franchise agreements.

Training and Other Assistance

A common reason for investing in a franchise, rather than starting your own business, is training and assistance. The disclosure document should explain the franchisor’s duties to train and assist you. The level of training and assistance offered may be limited or conditional.

Advertising

Most franchise agreements require that a percentage of a franchisee’s income be paid to the franchisor for advertising. The franchisor usually controls the advertising fund, and is not required to spend it for the specific benefit of the franchisees who pay into it. For example, the franchisor can use the fund to pay for regional or national advertising which does not reach your customers. Most franchise agreements also require that franchisees spend a specific percent of their gross sales on local advertising, in addition to the advertising fee. The disclosure document provides information on advertising costs. Also look for the following provisions:

Do franchisees have any vote over how the advertising dollars are spent?
Will any of the advertising funds be spent on advertising or marketing in your area?
How much of the advertising fund is spent on actual advertising versus administrative and other expenses?

Current and Former Franchisees

The disclosure includes information about current and former franchisees. The disclosure should contain the names and addresses of current franchisees. You are free to talk to both current and former franchisees. They may support the franchisor claims or, conversely, have adverse information. If many franchisees have left the franchise system, there may be problems.

Some franchisors specify particular franchisees to contact. Be cautious as these individuals may be franchisor friendly or otherwise not representative. Finally, try to find out if there is an independent franchisee association rather than franchisor advisory council. If an independent franchisee association exists, contact its members.

Earnings Claims

Prospective franchisees usually want to know how much money they can make in a franchise business. Information about financial performance, including sales and profits, is proscribed by the FTC Rule. If a franchisor makes such claims they must be in writing in the disclosure document. All earnings claim information should be reviewed with an experienced accountant or a business advisor.

Financial History

The franchisor’s financial statements are required attachments to the offering circular. If the franchisor is financially troubled, the company may go out of business after you have purchased a franchise. An accountant can help you review the franchisor’s financial statements.

Lawyer and Accountant

An experienced accountant is important for many reasons areas: reviewing the company’s financial statements, and studying any earnings history or projections and the assumptions. An experienced franchise attorney can help you understand your rights and duties under the contract.

Better Business Bureau

Most cities have a local Better Business Bureau. You can ask for consumers or franchisee complaints about the franchisor especially the Better Business Bureau outlet in the franchisor’s home city.

Government Departments

A limited number of states regulate the sale of franchises. Typically these laws are enforced by state Division of Securities or the Office of the Attorney General. California franchises are regulated by the Department of Business Oversight, formerly the Department of Corporations.

Federal Trade Commission (FTC)

The Federal Trade Commission has a federal rule requiring disclosure of key specified areas of information to prospective franchisees. But there is no right to a private lawsuit under federal law regulation rule. But some states have similar statutes providing relief including California. The FTC website has information on franchise issues, visit http://www.ftc.gov or call toll-free, 1-877-FTC-HELP (1-877-382-4357), TTY: 1-866-653-4261.

Investigating Franchise Offerings