When reviewing the franchise agreement a prospective franchisee should pay careful attention to the territorial provisions contained in the agreement.  It is important to protect yourself from territorial encroachment and competition from both the franchisor and other franchisees.

Territorial encroachment is a frequent complaint from franchisees.  Usually this involves the franchisor granting a new franchisee a territory “too close” to an existing franchisee.  Sometimes it involves an affiliate of the franchisor placing an affiliated franchise (selling similar products) too close to the existing franchisee.  Unless the franchise agreement creates express protection for the franchisee’s defined territory, a court may be reluctant to find a franchisor encroached on the franchisee’s territory.

Be sure to review the territory provisions of the franchise agreement to make sure you have a protected territory.  The Iowa Franchise Act does provide some protections against encroachment.  The downside is that while these protections may help you in litigation the damage may already have been done when you get to that point.  Moreover, there never any guarantees of success in litigation.  Be proactive and discuss the territory provisions up front with the franchisor during the due diligence process.

In its January issue, Entrepreneur Magazine published its Annual Franchise 500 for 2007.  One of the more interesting articles in the issue had to do with conducting due diligence.  As I recommended in a previous post the article discussed the importance of interviewing as many franchisees as possible in order to gain information about the franchisor.  Unfortunately most prospective franchisees do not conduct even basic due diligence, the article says.  Here are highlights of the article:

If you want to know more than the splashy brochures and franchise salespeople will tell you, then roll up your sleeves.  You can use a variety of methods to dig deeper and get the real lowdown on a franchisor.  The good news:  Most of these techniques are cheap or free.

1.  Mine Franchisees:  Be sure to ask tough questions.  Don’t just shoot the breeze.  Also visit franchisees at their stores.  You get more information and it is an opportunity to see the franchise in operation.

2.  Dig in the UFOC:  The UFOC lists a great deal of information but many franchisees do not even give it a glance.  The UFOC will contain information about lawsuits, revenues and management.

3.  Ramp Up Research:  Search the Internet.  Are there any gripe sites?  See UPS Store www.thebrownboard.com and Quiznos www.toastedsubs.info as examples of gripe sites.  Be sure to take what you read on the Internet with a grain of salt and verify what you learn.

4.  Meet the Management.  Ask the tough questions of management as well.  One expert recommended that you ask the franchisor whether they will let you out of their franchise agreement if you are unhappy?  If they respond "Yes", they are lying and will say anthing to get you to sign.  (Franchise agreements are enforceable contracts and I have yet to deal with a franchisor that will let you out of an agreement voluntarily).

5.  Know the Market.  Do the market research and understand how the franchise fits into the competitive picture.  Also, think about how the market is going to change. 

6.  Get Advice.  The article advises to go to SCORE, have an accountant review the franchisor’s financials and have an attorney review the franchise UFOC and franchise agreement.

Update:  I received an email today from a franchisee regarding this post.  He pointed out that the most difficult  information to obtain and verify is franchisee profitability.  He pointed out that the profitability of the franchisor and the franchisees is not always related.  He correctly stated that sometimes those selling franchises make money while the franchisees do not.  And it is not always due to lack of due diligence on the part of the franchisee.  It may be because of inaccurate information supplied by the seller or franchise support that was promised but never delivered.

Forbes Magazine had an interesting article that provides Ten Good Reasons Not to Buy a Franchise.  Number 1 on the list is Questionable Profitability.  That makes extensive due diligence all the more important if you are considering a franchise purchase.   

Franchise Law Blog reported that a group of Quiznos franchisees have filed a class action against the Denver based sandwich chain in Wisconsin.  The lawsuit contends that the franchisor forces franchisees to buy food and supplies from Quiznos and affiliates at inflated prices while setting retail prices so low the franchisees cannot profit.  The lawsuit also alleges that the franchise omits or misrepresents key facts about its business operations when selling the franchise. 

Quiznos denies the allegations and intends to vigorously defend the lawsuit.

Regardless of the outcome the lawsuit it provides an important lesson for prospective franchisees who are reviewing a franchise agreement.  Many franchise agreements contain restrictions on the products and suppliers the franchisee may use.  While this may seem reasonable in the beginning, (after all your buying a proven system, right?) many franchisees discover later they can get cheaper products and find better suppliers than the franchisor’s system.  After some time franchisees may begin to question why he or she is paying for higher priced products along with royalties which eat into profits even more.  When this happens franchisees tend to get upset and file lawsuits like the one against Quiznos. 

If the franchisee agreement you are considering contains restrictions on products and suppliers be sure to consider those provisions very carefully.  Be prepared to ask the tough questions of the franchisor when it comes to products and suppliers.  Also, don’t take for granted just because you are going with a top selling franchisor that you are getting the most for your money.  Above all, make sure to talk with as many current franchisees as possible and conduct your due diligence.

In his monthly newsletter, Joe Cooney of Frannet points out the categories and questions you should ask franchisors to provide a starting point in your due diligence process.  Those categories and questions include:

1.  Competitive Advantage of Product or Service

How is your system better than others?  Who are your competitors?  How does your business match up?  Who are your suppliers?  What are the prices of your products?  Are your products priced fairly?  Are there any restrictions with regard to products and services?

2.  Time Tested, Standardized Franchise System

How long have you been franchising?  How many franchise units do you operate?  How many units have you closed in the last three years?  How many units have been transferred or sold in the last three years?  How many units do you plan to open over the next three years?  What is the initial investment and what do we get for that?  What are your fees?  What earnings claims do you make?  What improvements have you made to your system recently?

3.  Strong Franchisor Support

How do you support franchisees?  What is the initial training process?  What support do you provide after the franchise is up and running?  What will I hear from franchisees on this subject?

4.  Financial Strength and Management Experience

Describe in layman’s terms the financial strength of the franchise system.  How much revenue comes from initial fees and how much from royalties?  Is the franchise publicly traded and how has it performed?

5.  Mutual Interest of Franchisor and Franchisee

How will franchisees describe their relationship with the franchisor?  Supportive?  Combative?  Have there been any lawsuits or abritration proceedings?  What was the issue and how did it end?

Remember this is only a start for the due diligence process.  You should be sure to interview as many franchisees as possible in order to better understand the franchisor and its system. 

Frannet is also offering free webinars on franchise opportunities in specific industries.  If you have any questions about the webinars you can email Joe Cooney at jcooney@frannet.com

If you are considering a franchise you should conduct appropriate due diligence. One of the most important things you should do is contact as many current franchisees as you possibly can. For some reason this is often overlooked.

I strongly suggest you keep talking with current franchisees until you find someone who is willing to describe some problems or issues with the franchisor. Trust me – you will learn a lot more about the franchisor in that conversation than all the glorifying remarks put together. Because a franchisee has a problem does that mean you should look elsewhere? Not necessarily. It just means you are now able to make your decision with open eyes.

Click here for more information regarding franchise UFOC and agreement review services.

With the help of Doug Mitchell and Andy Brudtkuhl I will be going live with an Interactive Learning Environment to complement this blog very soon.   The Rush on Business Legal Wire will focus primarily on employment law, franchise due diligence  / investigation issues and business purchase or sale considerations.  I also hope to attract top speakers to participate in the process.  The online seminar presentations will include in-depth written materials, audio presentations, podcasts and possibly video.

Forums will also be available for you to share your insights and ask questions.  Similar to the blog format, I won’t be able to answer questions regarding specific situations but we can discuss topics generally.

I welcome your comments and suggestions on topics you would like to hear more about.

Are you considering a franchise business?  Read this blog post on evaluating the strength of your franchisor before signing on from the First Prize Franchise blog.

I posted on this a couple of years ago but  I consistently see people who invest their life savings tinto franchise operations.  Some of these people achieve great results but many (perhaps even a majority) do not. What separates the good from the bad? 

One critical aspect to consider in my view is the brand itself.  Is the brand recognizable?  If not, the franchise better have a fantastic system, unique concept or protected intellectual property.  Otherwise, I think you need to question up front whether the franchise is right for you.

There is no also validity to the claim that franchise operations are less likely to fail than non-franchise operations. The truth is that franchisees fail at a rate that is similar to non-franchise businesses. In fact, the International Franchising Association has discouraged all franchisors from making such claims.  So careful due diligence is important when considering a franchise opportunity. One of the best things you can do is talk to as many existing (and former) franchisees as possible. Also, consider several key disclosure issues including:

  1. Franchisor’s litigation history;
  2. Amount of the initial investment;
  3. Vendor rebates and products you must buy from the franchisor;
  4. Earnings claims made by the franchisor;
  5. Franchisor’s financial statements;
  6. Trends concerning the number of outlets.  It is important to closely review the information regarding outlets. Carefully study the number of transfers and not just the number of closures.  A high number of transfers may be an indication that franchisees in the system are struggling, but bad stores have not been shut down. 

And finally, be willing to walk away. This is the paradox of successful negotiation. Those that are willing to walk away usually find they get more in negotiation, especially in today’s economy. Many franchisors are willing to make a deal these days. Don’t get in a hurry in your negotiations. You may be able to secure important concessions if you are patient.

 

I recently received an email from a business brokerage advertising their services.  In the email the brokerage said they have "low-risk" businesses and franchises for sale. While that may make for good marketing – I must unfortunately say that "low-risk" businesses do not exist in my opinion. If our struggling economy has shown us anything, it has demonstrated that risk is inherent in business. To advise otherwise minimizes the enormity of the decision to purchase a business.

Now don’t get me wrong. I am not knocking the business brokerage. It’s their job to sell businesses and that’s just what they are attempting to do. But the prospective buyer should be more cautious and take the time to understand the inherent risks of ownership in the business you intend to buy.  It is absolutely critical to conduct due diligence. Appropriate due diligence includes examination of the following areas in the business:

  • Organizational documents and good standing with state and/or federal authorities
  • Financial information
  • Physical assets
  • Real Estate
  • Intellectual property
  • Employees and employee benefits
  • Licenses and permits
  • Environmental issues
  • Taxes
  • Material contracts
  • Product and service lines
  • Customer information
  • Litigation
  • Insurance Coverage
  • Professionals
  • Articles and publicity

See this due diligence checklist for more details.  It is a very comprehensive checklist.  The level of due diligence will likely vary with the size of the business transaction but this list should give you a good outline of the issues to consider. 

 

In this current economic downturn many people will lose their jobs.  Many of those individuals will turn to franchising as a form of business ownership instead of opting for another position in the corporate world.  While franchising may be a legitimate option for some, it is important for prospective franchisees to remember that it is not often very easy to get out of a franchise agreement.  Investing in a franchise is not a decision to take lightly.

A typical franchise agreement may last anywhere from 5-10 years and have options for renewal.  Often franchisees mistakenly believe they can get out of the franchise agreement if things go bad.  The reality is that the written franchise agreement usually remains in force and often the franchisor has rights to sue the franchisee for lost royalties if the franchisee does not pay.  Not to mention potential problems you will have with your lease and/or other contracts.

So before you buy a franchise follow these steps as outlined on the FTC Website:

  • Study the disclosure document and proposed contract carefully.
  • Interview current owners in person. (They should be listed in the disclosure document.) Visiting them in person may help you identify any that are "shills" — people paid to give favorable reports. Don’t rely on a list of references selected by the company because it may contain shills. Ask owners and operators how the information in the disclosure document matches their experiences with the company.
  • Investigate claims about your potential earnings. Some companies may claim that you’ll earn a certain income or that existing franchisees or business opportunity purchasers earn a certain amount. Companies making earnings representations must provide you with the written basis for their claims. Be suspicious of any company that does not show you in writing how it computed its earnings claims.
  • Sellers also must tell you in writing the number and percentage of owners who have done as well as they claim you will. Keep in mind that broad sales claims about successful areas of business — "Be a part of our $4 billion industry," for example — may have no bearing on your likelihood of success. Also, recognize that once you buy the business, you may be competing with franchise owners or independent business people with more experience than you.
  • Shop around. Compare franchises with other business opportunities. Some companies may offer benefits not available from the first company you considered.
  • Listen carefully to the sales presentation. Some sales tactics should signal caution. For example, if you are pressured to sign immediately "because prices will go up tomorrow," or "another buyer wants this deal," slow down. A seller with a good offer doesn’t use high-pressure tactics. Get the seller’s promises in writing. Any oral promises you get from a salesperson should be written into the contract you sign. If the salesperson says one thing but the contract says nothing about it or says something different, it’s the contract that counts. If a seller balks at putting oral promises in writing, be alert to potential problems and consider doing business with another firm.
  • Consider getting professional advice. Ask a lawyer, accountant, or business advisor to read the disclosure document and proposed contract. The money and time you spend on professional assistance, and research — such as phone calls to current owners — could save you from a bad investment decision.

In representation of a new franchisor I have recently been on the other end of this investigation process. But it is clear to me that a good franchisor will not discourage you from conducting due diligence.  You should be very wary of high pressure sales tactics.  Don’t be in a hurry.

 

All Business has a decent article describing the ten key provisions of a franchise agreement.  However, I do take issue with the comment in Section 1 that "most franchisors offer ongoing support including administrative and technical support."

As I discussed in my last post on franchising, it is my experience that "most" franchisors DO NOT offer much in the way of ongoing support including administrative and technical support.  I believe this is a major item that separates the good franchisors from the bad ones.  And trust me, the MAJORITY of franchisors I have seen are downright awful in this category.

The majority of franchisors are good at only one thing – getting you into business.  After that, you’re on your own and you’ll be left to wonder why you are paying all those franchise royalties.  Perhaps harsh words for the industry overall but the truth hurts.  If you are buying a franchise make sure to do your due diligence and find those franchisors with a system for ongoing support.  Otherwise, why buy a franchise?