The franchise salesperson points to a map covered with colored dots.

Each dot represents a location. More dots are coming. The brand is entering new states, signing new franchisees, and projecting record growth.

Every dot looks like proof that the franchise is succeeding.

It may also represent another promise the franchisor must have the money and people to keep.

Prospective franchisees usually ask whether their location can make money. They study sales, rent, labor, royalties, debt, and opening costs. Those questions are essential.

But there is another business you need to evaluate before investing in your own.

The franchisor.

A strong concept can struggle under a franchisor that grows too quickly, lacks sufficient capital, or depends on selling new franchises to fund existing operations. Training may deteriorate. Field support may become difficult to reach. Marketing promises may exceed available resources.

You are entering a long term relationship with the company responsible for protecting and developing the brand.

Before you ask how quickly the system is growing, ask whether the franchisor is strong enough to support that growth.

Growth Is Not the Same as Health

Growth is easy to promote. Support capacity is harder to see.

A franchisor can award dozens of new territories and describe the demand as momentum. Yet every new franchisee needs training, site assistance, technology, marketing guidance, and operational support.

If franchisees multiply faster than support resources, the system may become less valuable to each owner even as the brand grows.

The Federal Trade Commission warns prospective franchisees that rapid growth does not guarantee franchisee success. A franchisor that expands too quickly may lack the financial resources or experience to provide the services it has promised.

Ask what has grown besides the number of locations. Has the training team expanded? How many field support employees serve the system? How long does it take to receive help with an operational problem?

The number of new locations tells you how effectively the franchisor sells franchises. It does not tell you how effectively the franchisor supports them.

Start With Item 21, But Do Not Stop at the Bottom Line

Item 21 of the Franchise Disclosure Document contains the franchisor’s financial statements. Established franchisors generally provide three years of audited financial statements, while certain newer franchisors may qualify for phased in requirements.

Many buyers flip past these difficult pages. That is a mistake. You may rely on the franchisor’s system for years. Its financial condition matters.

An audit does not mean the franchisor is financially strong. It means an independent accountant examined the statements and issued a report. Read the auditor’s opinion and footnotes, not merely the income statement.

Ask an accountant to help you evaluate:

• How much cash does the franchisor have?
• Can it meet its current obligations?
• Has it produced recurring profits or recurring losses?
• Is operating cash flow improving or deteriorating?
• Does the balance sheet show positive equity or an accumulated deficit?
• Is debt increasing?
• Are there significant obligations to affiliated companies?
• Do the footnotes identify uncertainty, unusual transactions, or dependence on related parties?

One bad year does not necessarily mean the franchise is unstable. A young franchisor may be investing heavily in people or technology. The goal is to understand why a loss occurred, how the company is funding it, and whether its explanation is credible.

How Does the Franchisor Make Its Money?

This may be the most revealing question in this article.

Healthy systems generally benefit when franchisees generate sustainable sales because ongoing royalties grow with franchisee revenue. The parties’ interests are not identical, but they are connected.

Concern increases when a franchisor depends heavily on initial fees, equipment sales, vendor payments, or other revenue collected before a location demonstrates success.

Initial franchise fees are not automatically problematic. But buyers should understand whether the franchisor has enough recurring revenue to support existing owners if franchise sales slow.

Ask the franchisor what percentage of its revenue comes from continuing royalties compared with initial fees and other sources. The answer may not be obvious from the financial statements. An accountant can help identify the right follow up questions.

Then ask something even more direct:

If the franchisor stopped selling new franchises for twelve months, could it still support the franchisees it already has?

Item 20 Shows What Is Happening to the Locations

Financial statements tell you about the franchisor. Item 20 helps you examine what is happening across the system.

Item 20 reports three years of openings, transfers, terminations, nonrenewals, reacquisitions, and other closures. It also identifies signed locations that have not opened and projected openings for the coming year.

Do not focus only on the total number of locations at year end. Study the movement underneath that number.

A system may open thirty locations while twenty others close, transfer, or leave the brand. The headline is growth. The more important story may be turnover.

Compare annual departures with the number of locations operating at the beginning of each year. Are closures increasing? Is the franchisor reacquiring troubled locations? Are many signed locations failing to open?

No fact provides an answer by itself. Transfers may reflect successful sales, while a closure may result from poor management. Several departures across different markets, however, deserve investigation.

Use the Item 20 tables to decide whom to call and what to ask.

Talk With the People Behind the Numbers

Current and former franchisees can explain what the documents cannot. Ask whether support has improved or declined as the system has grown. Find out how quickly the franchisor responds when sales fall, technology fails, or local marketing does not work.

Former franchisees may provide context for terminations, closures, and transfers. Ask what caused them to leave and how the franchisor responded when problems emerged.

Compare those conversations with Items 3 and 4 of the FDD. Item 3 discloses certain litigation involving the franchisor and other covered persons. Item 4 addresses bankruptcy history. Litigation is not unusual in business, and a lawsuit does not prove wrongdoing. Repeated disputes involving similar complaints may reveal a pattern worth examining.

You are not searching for a perfect franchisor. You are looking for consistency between its promises, financial capacity, system data, and franchisee experiences.

Ask the Franchisor to Explain Specifics

Bring specific questions to the franchisor rather than asking whether the company is financially healthy.

Ask:

• What investments are being made in training and field support?
• How many franchisees does each support employee serve?
• Why did terminations, closures, or transfers increase in a particular year?
• What happened to signed locations that never opened?
• Which services would be reduced if franchise sales slowed?
• What has leadership learned from locations that failed?

Strong franchisors should be able to discuss setbacks without becoming defensive. Evasive answers do not prove a serious problem, but they do not reduce the risk either.

Discovery Day is designed to help you become comfortable with the franchise. Use part of that day to become comfortable asking uncomfortable questions.

Investigate the Business Behind Your Business

An appealing product and enthusiastic owners do not eliminate the need for a financially stable and operationally capable franchisor.

Read Item 21 with an accountant. Trace the changes reported in Item 20. Review Items 3 and 4 for context. Speak with current and former franchisees. Ask whether the support organization has kept pace with franchise sales.

Most importantly, determine whether the franchisor’s financial success depends on helping franchisees succeed or simply on continuing to sell franchises.

Return to the map covered with colored dots.

Each dot represents more than growth. It represents a franchisee who invested money, accepted risk, and trusted the franchisor to deliver a system worth following.

Before adding your own dot to that map, make sure the company behind it is strong enough to keep its promises.

ABOUT THE AUTHOR

Rush Nigut is a franchise attorney with more than 30 years of experience representing franchisees, franchise buyers, and business owners. He helps prospective franchisees evaluate Franchise Disclosure Documents (FDDs), negotiate franchise agreements, and protect their investment before they sign. His mission at Rush on Business is to help entrepreneurs make smarter franchise decisions through practical legal and business insights.