Buying a franchise is a big decision that can impact your finances for years, if not the rest of your life. As a result, it is critical to carefully choose the franchise opportunity you want to pursue.
Choosing a franchise requires consideration of numerous factors. When going through the due diligence process, it is important to compare multiple competing franchise opportunities, and you will need to commit yourself to devoting the time necessary to make an informed decision.
While this can be tedious at times, it is well worth it, as you need to make sure you choose the franchise opportunity that provides the greatest chance of long-term financial success.
What are the factors you need to consider when evaluating franchise opportunities? Here are 15 key factors to consider before you sign a franchise agreement:
When buying a franchise, it is important to choose a franchise concept that interests you. You will be spending a lot of time working on the business (and perhaps working in the business as well if you plan to be an owner-operator), so you need to choose a concept that you care about. Your personal experience is important as well. While you don’t necessarily need to have prior business experience to buy a franchise, if you’ve never crunched numbers or spent all day in a commercial kitchen, a tax preparation franchise or restaurant concept might not be right for you.
Access to financing is a key preliminary consideration as well. Depending on how much you can afford to invest, certain types of franchise concepts might be off the table. While there are a variety of franchise financing options available, you need to be careful about the financing option you choose as well. For example, while some first-time franchisees pull money out of their 401(k)s, you should only do this if it will not impact your ability to retire at age 65.
The total initial investment for opening a franchise can range from tens of thousands to millions of dollars. Once you decide how much you are comfortable investing, you will want to start looking at franchises that interest you in your price range. When comparing franchise opportunities, look at how the initial investment estimates in Item 7 of the franchisors’ Franchise Disclosure Documents (FDDs) differ, and then perform your own financial analysis to determine how much it will really cost to open your doors
Royalty fees and advertising fund contributions are typically calculated as percentages of franchisees’ gross revenue—and they typically combine to fall somewhere in the range of five to eight percent. The weekly or monthly fees you have to pay your franchisor can have a huge impact on your profitability, so it is important to compare franchisors’ royalty fees and advertising fund contributions as well.
Some franchisors provide financial performance representations (FPRs) in their FDDs, and some do not. If a franchisor does not provide an FPR, this isn’t necessarily a bad sign—as many franchisors choose not to provide them due to the legal risks involved.
However, if you receive an FDD that includes an FPR in Item 19, you will want to review the franchisor’s representations carefully. Usually, FPRs will paint franchise opportunities in the most favorable light possible. They will often use cherry-picked data, and they frequently rely on assumptions that do not apply to all franchisees.
As franchising continues to grow in popularity, we are constantly seeing new franchisors come onto the scene. When buying a franchise, part of what you are paying for is the franchisor’s experience and expertise. If a franchise system is relatively new, and if its executives lack experience in franchising, these are not factors you should ignore. Instead, you should ask lots of questions to try to confirm whether you will receive access to the systems and support you need to be successful
Franchisors must disclose their recent litigation and bankruptcy history in Items 3 and 4 of the FDD. While most prospective franchisees skip over these Items when reviewing FDDs, this can prove to be a costly mistake.
There are a few things in particular to consider when examining franchisors’ Item 3 and Item 4 disclosures. For example, if the franchisor is regularly in litigation with its franchisees, this could be a bad sign. Similarly, if the franchisor has recently filed for bankruptcy or has a history of seeking relief in the bankruptcy courts, this could be a sign of poor management and overall system instability.
While there can be benefits to signing on as one of the first franchisees in your area (or in an entire franchise system), this comes with potential drawbacks as well. On the same token, if your local market is already saturated (or oversaturated), this can limit your profit potential as well. When buying a franchise, there is often a “goldilocks” zone when it comes to system size and location—you want just the right amount of saturation so that you can reap the benefits of owning a recognizable franchise without facing intrabrand competition
Along with access to the franchisor’s systems and support, one of the other main reasons to invest in a franchise is brand recognition. But, if no one in your market is familiar with the franchise you are purchasing, you won’t receive this benefit—at least not right away. This means that you won’t necessarily be getting the full value of franchise ownership. While the franchisor might have plans to expand quickly, these plans may or may not come to fruition. This is a risk you take when buying a franchise that isn’t already well-known in your geographic area.
There are several different permutations of territory rights in the world of franchising. While some franchisors offer truly exclusive territories, “protected” territories are far more common—and some franchisors do not offer any territorial protections at all.
It’s not always easy to tell what you are getting when it comes to territory rights, and in many cases, franchisors’ salespeople won’t have a clear understanding of what their companies offer. As a result, even if a representative tells you that your territory will be “exclusive,” you shouldn’t necessarily assume that this will be the case. Territory rights can have a huge impact on a franchise’s profit potential, and you don’t want to sign a franchise agreement only to later discover that the franchisor has the right to open a company-owned outlet in “your” territory.
Generally speaking, a healthy franchise system will grow over time. While some franchisees will inevitably leave the system, you should expect to see more openings than closings in Item 20 of the FDD. If a large number of franchisees have recently left the system, you should try to find out why. The exhibits to the FDD should include current and former franchisees’ contact information, and you will want to reach out to several current and former owners to learn about their experiences.
When you buy a franchise, you are typically only buying the right to operate for a two or three-year term. If you can’t renew when the initial term expires, you will lose your franchise (and everything that you invested in it). As a result, understanding the conditions for renewal is extremely important. If your “right” to renew is effectively subject to the franchisor’s discretion, this is most likely an issue that you will want your lawyer to address during your franchise agreement negotiations.
Understanding the conditions on your right to transfer is important as well. Even if you have no plans to try to sell your franchise, ensuring that you have reasonable transfer rights is still a key component of effective risk mitigation. If you cannot feasibly transfer your franchise (or if your franchisor has an overly one-sided right of first refusal), this can leave you with no way to recoup your investment.
Eventually, your franchise will come to an end. When it does, your options will depend—in part—on the post-termination covenants in your franchise agreement. If the non-competition and non-solicitation clauses in your franchise agreement are overly one-sided, you could be significantly hamstrung in your ability to buy another franchise or start your own independent business. Franchise agreements frequently include provisions for “lost future royalties” and other post-termination liabilities as well. These provisions present substantial risks, and it is important to discuss their implications with your lawyer.
Finally, when buying a franchise, it is important to consider the franchisor’s sales tactics and the overall quality of the franchise offering. If you are getting the hard sell, this may suggest that the franchisor is having trouble attracting quality candidates. Likewise, if the FDD and franchise agreement are poorly written, or if you can’t get answers during your due diligence, this should give you pause about the quality you expect from the franchisor if you decide to move forward
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