How to Avoid a Bad Franchise Opportunity

With hundreds of superior franchise opportunities available today, there is no reason for you to settle for less than the best opportunity in your investment range. There's no single indicator to look for when protecting yourself from the few franchise scams - for each franchise opportunity, you need to conduct proper due diligence by weighing all of the indicators when making your assessment.

But how is it possible that franchise scams can even exist? Partly, it's the ease of developing and offering a franchise opportunity. But it also is made possible because some potential franchisees invest in bad "opportunities" before they do their homework.

Basic research when evaluating a franchise

You can understand whether a franchise opportunity is for real even before you get to the step of contacting the franchisor:

• Research news stories about the company and the industry.

• If the company is public, look at the information available from their SEC filings.

• Visit their website and get information about their consumer offering, as well as their franchise offering. (Franchisors often have a separate website dedicated to their franchise opportunities.)

• Learn what you can about their management, and thoroughly research their background.

• Compare the company to its competition – both franchised and non-franchised.

• Locate some of their stores and speak to existing franchisees.

Another reason to do your homework before you contact a franchisor is that they have experienced franchise salespeople working for them. It's easy for a great franchise salesperson to get you excited about their opportunity, worried that you may not qualify to be accepted by the franchisor, and thus distracted from possible warning signs that the opportunity may not be all it seems to be.

Contacting the franchisor

When you first contact the franchisor, ask them about their franchisee selection process. You want a franchisor that has a plan for introducing you to the opportunity, and one that makes certain you are qualified to become a franchisee.

Any franchise system is only as strong as its brand, and that brand rests to a great extent on how well the other franchisees in the system perform. If the franchisor overly focuses on your financial qualifications and does not have criteria for the selection of qualified franchisees, then in all likelihood anyone who can afford it is allowed to join the system –in which case, your investment may be at risk.

If the company is willing to “sell” you a franchise before you visit with them at their company headquarters, which is another indication of a less than stellar opportunity. While you should want to do a thorough evaluation of the franchisor, a great franchisor needs to also do a thorough evaluation of you.

Visiting the franchisor's headquarters

What should you be looking for when you visit the franchisor’s headquarters?

Meet as many of the franchise support people you can who will be working with you. Conduct an assessment of whether you think they have the experience necessary to do their jobs.

• Are there enough qualified support personnel to give you comfort?

• While a new franchisor may be thinly staffed and your support may be coming directly from the founder (which often is outstanding), is there a management team in place to look over the franchisor’s existing retail operations, and will the founders have time to provide you with the support they are promising?

• Is their time stretched between managing existing operations and selling new franchises, and do they have enough time to support you?

Look at the condition of their offices. They may be small and not as extensive as other franchisors, and often new franchisors don't have extensive offices, but do you get the feeling of success, or of impending doom? Alternatively, do all of the company’s resources seem to have gone into marble and brass, or does it seem that the company is investing in computer systems, personnel, training programs, and other areas of support you will require?

Analyzing the franchise disclosure document

When you get the franchisor's disclosure document, be prepared to analyze it thoroughly. If the opportunity still interests you after you study the company’s information, you should engage a qualified franchise attorney, consultant, or accountant to help you in conducting your in-depth due diligence. Don't rely on the franchise salesperson or broker for advice; no matter how friendly and supportive they are, always remember that they work for the franchisor.

Indicators of possible franchise scams

Indicators of franchise scams can be found by investigating the following:

Does the company or its affiliates have experience in the business being offered? We’re not talking about a related business, but the exact business. For example, if the company has successfully been operating 4,000-square-foot stores, but the franchise opportunity is only for 1,000-square-foot stores, it’s not the same business no matter what they say. The same works in reverse – bigger is not always better. If you will be opening your franchise in Boston but the only experience the company has is in Texas, it’s not necessarily the same either. Have they done the necessary research to determine if the concept will work in Boston, or are you going to be their cold weather guinea pig?

Does management have a history of success? Success as a franchisor is wonderful, but is it in the industry in which you will be operating? Does management of the franchise system know how to operate your business successfully? If not, what type of support are you likely to get? How frequently have they changed jobs? How well are their former companies doing? Have they been involved in franchise litigation during their careers?

• If the management of the franchisor has been with other franchise systems, call the existing and past franchisees of those systems and find out how well they did in the past. A mix of executives with experience in the business – and as successful franchisors – is a great benefit to franchisees.

What is the financial condition of the company? Your investment is likely to be significant. Between debt and equity, in some franchises your investment may exceed seven figures. Even new franchisors need to have financial resources to meet their commitments.

• What about the franchisor – will you have more skin in the game than they do?

• Do they have a history of profitability?

• Are they earning their revenue from royalties and other continuing sources of revenue, or are they relying on the sale of the next franchise to make payroll?

Are you getting value for your money? If it’s a well-known established brand and the franchisees in the system are doing well, of course you should expect to pay a sizeable franchise fee. But, if it’s a new franchise system and your training lasts only a few days, are you paying more than it’s worth? Paying a franchise fee of $35,000 or more when you are only getting one week of training from a new franchisor with limited experience, simply because they have a great brochure and a spectacular franchise sale program, doesn’t seem to be value for your money. Ask the other franchisees in the system if they got value for their money, keeping in mind that franchisees new to the system may not know that yet.

What’s the franchisor’s litigation, bankruptcy or regulatory history? Franchisors must disclose relevant litigation, bankruptcies, and regulatory problems. Sometimes litigation is good: any franchisor that enforces system standards may occasionally need to sue its franchisees. If they are able to still maintain a good relationship with their other franchisees, then that type of litigation is an indication of a strong and responsible franchisor.

However, if there are pages upon pages of lawsuits from franchisees in the disclosure documents, that is not a good sign. You need to understand the basis for the lawsuits and make a decision based upon the facts. Your attorney can help you analyze the franchise litigation.

Is the franchise offered only in the non-registration states? Not every state reviews franchise disclosure documents or requires franchisors to register their offering before getting permission to offer franchises in that state. Outside of the franchise registration states, no one reviews the franchisor’s documents before they can offer franchises.

Sometimes companies don’t offer franchises in the registration states because those states do not fit into their geographic strategy. But, if a franchisor is offering franchises all over the United States except for the registration states, that may be an indication that their franchise would not meet the requirements of the registration states. You need to be very careful when you come upon opportunities that go out of their way to avoid the registration states.

Your attorney can give you a list of the franchise registration states, or you can look on the International Franchise Association’s website at www.franchise.org for that information.

Is the franchisor an IFA member? One final point that I think is worth making, is that active membership in the IFA, while not a guarantee that the franchisor is a worthwhile investment, is a strong indicator of a responsible franchise system. Active IFA members have available to them training programs, networking opportunities, and meetings in which they can exchange best practices with other franchisors.

If the franchise management has earned the designation of Certified Franchise Executive (CFE) from the IFA Education Foundation, that is also a good indication that they have spent time understanding best practices in franchise system management.

Above are just a few of the areas you need to assess in determining whether a franchise opportunity is a scam. I also encourage you to download a copy of my Making the Franchise Decision workbook from the Resources section of the MSA website: https://www.msaworldwide.com/franchise-resources/franchise-evaluation-tool/. It's a free franchise evaluation workbook for you to use in evaluating the different franchisors you are interested in.

Remember – a franchise salesperson who has befriended you has the advantage of having been through the franchise selling process hundreds of times, while this is likely to be your first experience investing in a franchise. Your outside advisors will be able to help you put aside your entrepreneurial burn to get into the game, and assist you in conducting a proper due diligence on the opportunity. Listen to them, and don’t get into a franchise unless you have the assistance of a qualified expert.