Franchising Series: How to Evaluate and Buy a Franchise
By Brad Mix | November 1, 2022
In part one and two of this series, we outlined the advantages and disadvantages of becoming a franchise owner, versus starting your own business from scratch. If you’re still interested after weighing the pros and cons, you’ll need to know the process and how to effectively evaluate franchise opportunities. So, let’s get started.
Process of Buying a Franchise
Initial Conversation with the Franchise: Your initial conversation will be with the Franchise Development Director who will answer your questions about the franchise opportunity and the requirements to become a franchisee. During this initial stage of evaluating the business opportunity, keep in mind the franchisor is also evaluating you to determine if you would be a good addition to their franchise family. Both parties need to determine if it will be a good fit for each other.
Franchise Disclosure Document (FDD): After you complete the franchise application, the franchiser will send you the FDD. The Franchise Disclosure Document contains background information and key details on the franchise opportunity.
Talk to Other Franchise Owners: The Franchise Disclosure Document will list all the other franchise owners and their contact information. The franchisor will recommend you contact some of the owners to get their input and experience about being a franchise owner.
Meet with Franchise Executive Management Team: At this stage, you get to meet with other members of the Franchise’s executive team, meet the leadership team and ask them additional questions on the franchise opportunity, and finalize discussions about becoming a franchisee. During this process, the executive team will also decide if you are a good fit for the franchise.
Franchise Agreement: After receiving approval from the executive team, the franchise will move forward and prepare your Franchise Agreement documents.
New Franchise Owner: Once you have consummated the Franchise Agreement and obtained the necessary capital, you are officially a new franchise owner.
How to Evaluate a Franchise Opportunity
After you have identified a potential franchise you are interested in, you need to research the franchise and perform due diligence on the business opportunity. Fortunately, franchise opportunities are easier to evaluate than starting your business, because of all the available information. The two most effective steps to evaluating a franchise opportunity is to review the Franchise Disclosure Document and talk to other franchisees in the network.
Franchise Disclosure Document (FDD):
The Franchise Disclosure Document (FDD) is a voluminous document that contains detailed information on the franchise. For example, the FDD for SCOOTER’S COFFEE, LLC franchise is 233 pages.
The information in a Franchise Disclosure Document (FDD) is divided into a cover page, table of contents and 23 categories called Items.
Earnings Claims: Item 19 of the FDD discloses financial performance of other franchisees including information about average sales levels, cost of goods sold and other operating expenses; by dollar amount and as a percentage of sales, and net operating income before debt obligations. When evaluating net operating income, you also need to consider the monthly and annual loan payments you will incur, if you obtain a loan to finance the acquisition, to determine the potential cash flow of business. Note: Approximately 60 percent of franchises provide earnings claims.
Initial Investment Requirements: Items 5 and 6 identifies new franchisees’ total start-up costs. A Florida SBDC Network business consultant can review the start-up costs and your personal financial position to determine your ability to qualify for a loan; if the franchise is financially feasible for you based on your personal financial position and ability to qualify for a loan.
Franchisor’s Earnings & Financial Position: Item 21 includes financial statements; Income Statement and Balance Sheet for the prior three to five years. You want to determine if the company is financially solid and profitable.
Is the franchise system stable, growing, or contracting?: Item 20 summarizes the number of franchised units. How many new units have been created in the last few years? Most importantly, you want to determine how many franchise units have closed in recent history; a large number of closures in the last couple of years is a red flag.
Franchise Territory: Item 12 and the “territory” provisions in the franchise agreement indicates if you will receive an exclusive franchise territory or if the franchisor and other franchisees can compete with you. Service franchises are more likely not to offer an exclusive territory.
Past & Pending Lawsuits: Items 3 and 4 tell you whether the franchisor or its management have been involved in material litigation or bankruptcy proceedings. Practically every franchise has lawsuits, even the best ones. Therefore you want to look for red flags like a class action lawsuit by a group of franchisees against the franchisor.
Past & Present Franchisees: Item 20 lists current and former franchisees. As part of your due diligence, you want to talk to five or six of them to ask them about their experience as a franchise owner. Two of those should be ones who started their business in the last two years, while two to three should be in business three to five years, and a couple should be successful long-term franchisees. It can also be informative talking to former franchisees to learn the reason they left the franchise system.
Franchisees Non-Disparagement Clause: In some instances, current and former franchisees are required to sign provisions restricting their ability to speak openly about their experiences, financings, and other matters with the franchise. Although, as part of your due diligence, you should speak with current and former franchisees. Be aware that not all such franchisees will be able to communicate fully with you or disclose their dissatisfaction about the franchise. Over the past few years, franchisors have been requiring signed agreements that include a confidentiality clause restricting disclosure of the terms and conditions of their agreements with the franchise and other matters.
Now that you have all of the pertinent information you need to get started, don’t forget to utilize the economic development professionals that are available to you at no-cost. There are multiple organizations out there solely dedicated to helping entrepreneurs be successful.