You think a franchise may be for you. You can’t wait to cut that ribbon and get your business up and running. But to avoid a false start, it makes sense to spend more time in the starting block. This post – the fourth in the FTC’s Franchise Fundamental series – covers key steps to take before you’re off to the races: 1) carefully evaluating critical documents that may (or may not) be attached to the Franchise Disclosure Document; 2) scrutinizing the financial performance representations included in the Franchise Disclosure Document; and 3) and running through every detail of the deal with an experienced attorney and accountant.
Evaluate the franchise documents.
The third post in the Franchise Fundamentals series covered points to consider when studying the Franchise Disclosure Document. But the FDD is just where your reading starts. As A Consumer’s Guide to Buying a Franchise explains, the FDD is just one of three critical documents you need to evaluate. The second is the Franchise Agreement itself – the binding contract between you and the franchisor, which should be attached to the FDD. The Franchise Agreement will typically restate some of the information in the FDD – your territory, franchisee payments, advertising and marketing standards, trademark use, the performance standards the franchisor will hold you to, renewal terms (including whether you may be asked to sign a new Franchise Agreement with materially different terms) or termination rights, etc. An obvious red flag would be any discrepancy between what’s in the FDD and what the Franchise Agreement says.
Furthermore, time may have passed between when you received the FDD and when you’re ready to sign the Franchise Agreement. Don’t approach the dotted line without asking the franchise seller if the franchisor has made any updates to the FDD or if there have been any changes to the financial performance information included in the FDD. If there have been, be sure to get copies of any updated information and study the documents carefully. Also ask the franchisor whether there are any differences between the Franchise Agreement that was attached to the FDD and the one you’re expected to sign. Confirm this yourself with a scrupulous side-by-side reading. If there are material differences between the two, the franchisor must give you more time to review those changes before you sign the agreement.
The third important document to review is the franchisor’s Operating Manual. The Operating Manual includes the nuts and bolts of how you’ll need to run the franchise – including the hours and days of operation, interiors, uniforms, equipment, mandatory suppliers, and other requirements that have a profound impact on day-to-day management. The FTC Franchise Rule doesn’t require franchisors to provide their manual, but it may raise another red flag if a franchisor isn’t willing to share it. Another factor to consider is that the Franchise Agreement may give the franchisor the right to change the Operating Manual at any time. Those unilateral changes may include things like redecorating, modifications to the payment systems, or new fees and product offerings – all of which may mean big extra costs to franchisees.
Scrutinize financial performance representations.
Item 19 of the FDD addresses financial performance representations – claims the franchisor makes about sales or earnings. The Franchise Rule doesn’t require a franchisor to provide that information, but if a franchisor has made representations of that nature, they must be in Item 19. If the franchisor or any franchise seller has said things about sales or earnings in discussions with you, but those claims aren’t in the FDD, raise the red flag.
Here are some other key considerations when studying financial performance representations.
- Potential earnings. If a franchisor makes claims about potential income or sales, the law says it must have a “reasonable basis” to back up the statements. A hope or a hunch isn’t enough. They need solid proof. They also must tell you the source and limitations of the data they’re relying on and any important assumptions on which the claims are based. You have a legal right to written substantiation that supports their claims, so be sure to ask.
- Average income. If a franchisor tell you its franchisees earn an average income of $75,000 a year, that doesn’t tell you much about how individual franchisees performed. Calculating earnings that way can allow the results from a few highly successful outlets to hide the disappointing results from other franchises
- Gross sales. Providing franchisees’ gross sales also has the potential for deception because it doesn’t factor in their actual costs or profits. An outlet with high gross sales on paper might be losing money because of high overhead, rent, and other expenses.
- Net Profits. Franchisors often don’t have data about franchisees’ net profits. But if you get that information, ask if it’s based on results from company-owned outlets. If they are, keep in mind that those results may differ from your own because company-owned outlets often have lower costs.
- Geographic Relevance. Earnings may vary with geography. If a franchisor provides sales or income numbers, ask if that data came from franchisees in your area. In addition, consult the FDD, which should state whether there are geographic differences between the franchisees whose earnings are reported and your anticipated location.
An important fact-check on any earning claims the franchisor makes to you will be your in-depth discussions with existing and former franchisees listed in the FDD – or those you identity from other sources. If their results don’t line up with what the franchisor has told you, it’s another red flag.
Franchisors may ask you to sign a statement – sometimes presented as a written interview or questionnaire – that asks, among other things, whether you received any earnings or financial performance representations during the course of buying a franchise. If they gave you any information about how much your franchise may earn, report it fully. Don’t be pressured to say otherwise. If you’re encouraged not to report the earnings representations, that’s a red flag. What’s more, you may be waiving any right to contest the earnings claims you used to make your buying decision.
Consult an attorney and an accountant.
Prospective franchisees may have a legal background or financial experience, but regardless, all prospective franchisees should consult an attorney and an accountant before deciding to buy a franchise. Think of it this way: A lot of surgeons need to have their appendix removed, but they don’t perform the operation on themselves. Hire an experienced attorney to review the Franchise Disclosure Document, the Operating Manual, and the Franchise Agreement with you. Discuss with your attorney if there are provisions in the Franchise Agreement you’d like to change. If the franchisor isn’t willing to negotiate, it could be a bad omen for the future.
Also consider consulting an accountant to review the franchisor’s financials and any financial performance representations. While you’re looking at the balance sheet line by line, your accountant may be able to discern things between the lines – where the “good stuff” often hides in financial documents. Even the most sophisticated titan of industry wouldn’t make a major financial commitment without talking it over with independent experts. Paying an attorney and an accountant up front could save you thousands (and a thousand headaches) in the future.
Next in the Franchise Fundamentals series: What to do if you spot questionable practices related to the sale of a franchise. Also check out earlier posts in the series: