Franchise Due Diligence
I have seen a number of articles talking about the 3 reasons that franchises fail, or the 7 reasons or the 5 reasons or whatever number of reasons that cause franchises to fail. Franchises can be quite complicated, and certainly anyone going into a franchise quickly learns that there are a very large number of factors to be concerned about, practically any one of which could lead to failure.
That being said, here are some of the more salient factors I am concerned about when we are helping a client consider buying a franchise.
Education
Before anything else, I start a new client who wants to buy a franchise, by telling them: “Stop. We will not be looking at any specific franchise yet. Learn all you can about franchising… Take your time… Educate yourself. When you actually start looking at a franchise, you will barely have enough time to assess the franchise, even with our help, and you will be lost without a good grounding.”
Readiness
After I am certain a client has educated themselves sufficiently (this may take weeks, or even months), I then ask: “Do you want to be in this business? Are you ready to invest your own money? Are you ready to borrow more money if need be? Do you have enough money to last what may be many months and can cover all the costs of looking at a number of different franchises, traveling, hiring attorneys, accountants and specialists? Do you then have enough money to last until the franchise turns profitable for you? Are you ready to put all your time and energy into the franchise? Do you know how to hire people? Do you know how to manage people? Can you handle working in a restrictive fashion, following all the rules, working for someone else’s brand? Will you have a partner? Are they fully capable in all the areas needed? Can you work well with your prospective partner? Do you work well with people, especially the public? Do you realize you will have to stay on top of many different things, such as employment law, banking, various kinds of insurance, corporate taxes, bookkeeping, marketing & sales, and on and on? Are your expectations of returns, quality of life, etc. realistic? How long can you last without an income until you can take out a regular income? Is your family ready to be put with barely seeing you for a long time, and if and when they do, how well will they put up with you most likely to be sleeping, or getting up in the middle of the night to work on paperwork, etc., etc., etc.?” There are lots more questions but I think you get the point.
If I am satisfied that the client is truly ready for all this fun, and their family is also totally ready to put up with all of this, then we can get into the basics.
Professional Members of the Team
Anyone getting into franchising will need a competent attorney, specifically skilled in franchise law, preferably with at least 10 years experience. A competent accounting firm, also with significant franchise experience, will also be required. Additional professional services people may be required in the specific arena of the franchise market space. If you don’t have a very good franchise attorney and an excellent accounting firm, we will not work with you.
The time to find these people is now, long before the first franchise is looked at. Meet several attorneys, several accountants, and several in each of the specialty professional services areas that may be needed. This is a critical part of your education, and of course building the team necessary to properly handle all the aspects of franchising.
Franchise ConsultantsCharles F. Bacon, CEO & Keeper of the Vision
charlesbacon(at) superdiligence (dot) com
Due Diligence, Inc.
www. superdiligence (dot)com
Be very wary of the ‘franchise consultants’ who are all over the place. Except in very rare cases, these people do not represent you, they represent the franchise! Do not work with such people. Deal directly with the franchise. Why should you pay additional fees for what amounts to a typically medium- to high-pressure salesman?
A Little Franchise History
The franchise concept first appeared in Europe in the Middle Ages, with sovereign rights being granted for all sorts of things, such as hunting on the King’s land, operating markets, operating ferries, and operating fairs, later moving into areas such as brewing beer and ale, and building roads. In the 1840s, the first franchises in a modern sense came into being, with German brewers granting franchises to taverns exclusive ale sales rights. 1851 marks the date the Singer Sewing Machine Company started offering sewing machine distribution rights, and in the 1880s, street car monopoly franchises started to be granted by cities. After WWII, the franchise format that is still with us today began appearing.
Early Abuses & Problems in the Industry
In the 1960s and the 1970s, there were huge abuses in the franchise world, and also lots of very poorly constructed, poorly managed and poorly capitalized franchisors.
New Laws & Regulations Come Into Being
One of the great things about the United States is that some of the laws actually protect the little guy! After all these abuses became so obvious, lots of laws came into being at the Federal and State level, the FTC set up the Uniform Franchise Offering Circular requirement in 1978, and also the International Franchise Association was created. Some US State laws are more stringent than the Federal laws, so check with your attorney or us to see if you are in one of these States, called registration States.
Your Best Friend, the UFOC
Moving on, prepare to make very good friends with the Uniform Franchise Offering Circular. This is the best single document that you will receive from a franchisor. Now here is where all that education and preparation comes in. By law, the franchisor and you cannot sign the franchise contract, nor can you pay the franchise fee, for an astoundingly long time of 14 days! Don’t mistake my point. It’s fantastic that such laws exist to protect people from franchisors who are greedy, naïve, crooked, or all three. It’s just that 2 weeks is not enough time to truly evaluate any franchise, even if you have our help. In any event, go through the UFOC as many times as it takes for you to understand every single word, getting help from your franchise attorney, accountant and specialists such as my organization. Over the many years, I have developed a number of atypical due diligence techniques. One of the more interesting techniques I use is to not only look at the current UFOC, but also get several older UFOCs to see what changes have occurred. It can be most fascinating to confront the franchisor with their own history! Of course if any one of those changes is substantive, I immediately advise my client to run, not walk, in the opposite direction.
Some Factors to Consider
Here is just a short list of some of the factors that I get into with a client considering a franchise:
* Communications: Keep track of every communication, every scrap of paper, every conversation, even in the hallway outside the conference room, so to speak. Write down everything, no matter how trivial it may seem. Keep track of every single person you communicate with. Some people even record everything, but don’t forget to get formal permission; otherwise you are breaking the law!
* Competition: Analysis of competitor documents is often very interesting (their UFOCs and other materials can be very useful)
* Contract: Among countless other things, every item, no matter how small, must be in the big contract. This includes any verbal agreements, which are worthless unless reduced to writing. And don’t be afraid to ask for addendums. Franchisors work very hard to have a standardized agreement, which is actually very important. But your situation may have any number of non-standard things to agree on, and stick into addendums.
* Correspondence: Registered letters are a very good idea for anything major. It is also very interesting to use written correspondence to re-ask questions and ask for a written response….. It is quite fascinating to see how answers change when someone has to put it in writing.
* Current and former franchisees: Talk with every current franchisee you can, and as many former franchisees as possible, especially on your own without the franchisor present. Ask every question from you, your attorney, your accountant and the rest of your team. One of the more interesting questions is “Would you have gone into this franchise knowing what you know now?” Another good question is: “Knowing what you know now, what are all the things you would do different?” Don’t forget to ask if there was anything different from any written documents they received from the franchisor, and then ask them if there is anything different in the new documents.
* Due diligence plan: Create a formal due diligence plan. Work with your attorney, your accountant and your specialist team to make sure this plan covers every possible item
* Entrepreneur Magazine: Check their ranking.
* Equipment selection: Lots of details here. Look closely at the franchisor’s requirements, and then measure against some competent equipment people’s opinions.
* Exclusivity and prohibition clauses (These are on you!... ex: you have to devote all your efforts to the franchise… or you cannot own anything like another business without their approval)
* Expansion: Generally I want to see fairly rapid franchisor expansion now, and planned.
* Experience and expertise of the franchisor (in many different disciplines!)
* Financing: How are you going to finance the fee, inventory, facilities, etc? Be really careful here. The SBA has good programs. Do not put all your family’s money at risk. Do not go the venture capital route. Angel investors are ok, but be careful that they understand franchising, and if they want to become involved beyond investment.
* Franchise shills: Ask every current and former franchisee if they are receiving or received any form of compensation from the franchisor in any way connected with helping the franchisor get new franchises.
* Franchisees out of the system: Check for so-called “renegade” franchisees
* Franchisees working together: Ask if other franchisees can help each other
* Franchisor Executive & Franchisee Coaching: What programs do they have, how long do these programs run, how much are the costs, what did other franchisees think of these programs, etc?
* Franchisor information: Collect every scrap of paper they offer, or display. You should also ask for: incorporation papers; bylaws; minutes of main board and shareholder meetings (typically annuals); financials (beyond the 3 years in the UFOC), and dig into the details of their P&L, cashflow and balance sheet statements; and their business plan.
* Franchisor Size: Look at the franchisor’s facilities and staff. If it looks too big, ask why, especially when these funds could be better used helping the franchisees, such as with marketing & advertising.
* Great Expectations (on your part, on the franchisor’s part, or both): Get real; get pragmatic… work with your attorney, accountant and specialist team to carefully construct a list of all your expectations, and how you are going to get there.
* Industry Associations: Find out what associations you should be joining
* Intellectual property: Check into all trademarks, patents, copyrights, trade secrets, licenses, service marks, and know-how packages. You may need a specialist intellectual property attorney to work with your franchise attorney.
* International Franchise Association membership: Very good if the franchisor is a member.
* Inventory selection: Similar to equipment. Look carefully at the franchisor’s requirements. For instance, ask current and former franchisees how much inventory was not needed up front, and on an ongoing basis.
* Lawsuits: Check for historical, current or pending lawsuits, especially to see if a significant number of franchisees have gone, are going, or plan to go this route.
* Liabilities: Have your accountant check into all the franchisor’s liabilities, go over this list with your attorney, and then listen to their combined opinion.
* Liens: Check for historical, current or pending liens.
* Location: Location, location, location. The old adage is true. Site selection is a critical area. We often recommend you get help from a competent commercial real estate broker who understands franchising.
* Management assistance: What is the ongoing management assistance program, costs, etc?
* Market: We have a really big sub-list here. Analyze your market thoroughly. Is the market saturated? What are all the key market trends? etc., etc., etc. This is another one of those areas that if you do not have the specific skills and experience, hire a solid professional to help.
* Marketing and sales activities and materials: What will the franchisor provide up front, and ongoing? Can you cooperate with other franchisees to get benefits of volume, multiple placements, etc., etc? What are your costs, now and ongoing? How often do the marketing and sales programs update?
* Marketing assistance: What is the ongoing marketing assistance program, what are the costs, etc?
* Master franchises (forget it!)
* Number of fully operating franchisees
* One of the fun questions is asking the franchisor what mistakes they made so far.
* Ongoing percentages: What does the franchisor charge for ongoing percentages, and what is the detailed breakdown?
* Operations manual: Look for a really serious, high quality manual.
* Other franchisors: What can be the other franchisors’ impacts on your franchise? (This can be a real problem, and often there is practically nothing you can do about it!)
* Publications: Learn which are the best industry publications to which you should subscribe,
* Publicity: Check back as far as possible, especially looking for bad publicity.
* Reduction Rate: Calculate the average rate of franchisees leaving, and look for unusual rates per year.
* Registration with your State agency
* Renewability requirements: When it comes time, can you renew, how easy is it, what are the costs, etc?
* Reputation, Trusted name in the marketplace: Without a good franchisor reputation, walk away,
* Resale: This is a huge area, with too much detail to list here. You really have to look very closely at all the resale issues from your point of view, the franchisors, and the other franchisees.
* Specialized training: Is there any? What is it? What are the costs?
* Start-up assistance: This is usually a long list. Go through this area very closely.
* Territorial protection (competition from other franchisees and/or the franchisor)
* Training: Really important… look at their training program carefully, as detailed as possible, talk with other franchisees, etc.
* Turnover rates: look back in time at least 5 years, preferably 10, to see how many franchisees are gone.
* Undercapitalization: You, and/or the franchisor! Either or both, walk away. If it is you, look at less costly franchises.
Again, the above list is only a small snapshot of the process. My complete list of due diligence requirements for a client to go through all that is necessary to pick, purchase and run a franchise runs dozens of pages.
Some other thoughts:
Testing
Don’t be put off by any testing, including personality profiles, even math and writing. Some franchisors do this more than others. They want to know if you are going to be the right fit, or if you have sufficient skills.
Franchise Business Models Changing
The old command-style franchisors, generally from several decades ago, are being replaced by more open-style franchise systems. These systems acknowledge the fact that the franchisor and the franchisees, working more closely together, can make a much better go at it.
The Facts About Franchise Failure Rates
I keep hearing that franchises fail less than other businesses. Franchises do survive the early years at a much better rate than other business models, and everyone widely quotes the Small Business Administration’s 95% franchise success rate. I am still shaking my head as to where the SBA gets its data. According to the prestigious MIT Sloan School of Management in their Sloan Management Review, the real facts are that not 5%, but three times that, 15% of all franchises fail in their very first year! And somewhere around the 3rd year, the rate of franchises failing goes up to about 30%, which is about the same failure rate as all other business models. Finally, the same source also points out a rather insidious practice, namely, the franchisor might buy back your franchise, even over your stringent resistance! Finally, if you take a look at the rate of failure of the franchisors, about 75% of all new franchise systems fail with a dozen years. As usual, it all boils down to carefully doing the very best due diligence possible when looking at a franchisor and the franchise you are considering purchasing.
Charles F. Bacon, CEO & Keeper of the Vision
charlesbacon(at) superdiligence (dot) com
Due Diligence, Inc.
www. superdiligence (dot)com
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