A Franchisee’s Guide to Due Diligence

A Franchisee’s Guide to Due Diligence

The franchise model continues to grow across a wide variety of industries because it works — and works well — especially when new franchisees find the concept of their dreams.  When you buy into a franchise system, you are buying more than just a brand name.  You are buying a system — a system that is the result of someone else’s knowledge, efforts and experience in order to come up with a complete instruction manual on how to do every single aspect of that business, and do it well, the first time around, not the tenth.

Due diligence is a very important aspect of franchise ownership

Before taking the financial and emotional plunge into franchise ownership, conducting the right due diligence will help ensure future happiness and avoid financial catastrophe.

You will want to make sure that not only is the franchise you’re investing in financially sound, but that it’s also a good fit for your personality and interests, and that the franchise culture is one that you believe in.  To get answers to your questions, you will need to do your research – which will include reaching out to other franchisees, and asking hard questions of the franchisor.

Once you’ve done your research and have had all of your questions satisfied, you can make an informed decision about what’s right for you.  Take your time and be thorough – this is a big decision!

Quantitative Due Diligence

The first thing that most prospective franchisees want to know about is the money side of things.  How much is the initial investment?  Also note the franchisor’s ongoing advertising fees and royalties.  Those are the easy figures to determine, as they are found in the Franchise Disclosure Document (FDD) – which you’ll receive early on in your conversations with the franchisor (if you don’t, it’s a red flag!).  Your franchise consultant will help you tease out what’s important from the FDD – and provide you with resources to help you interpret what you are reading.  Later in the process you will want to hire a franchise attorney to dig deeper and protect you from any hidden minefields that may be buried in the fine print.

The harder questions are:

  1. How much can I expect to see in profits as my business grows?
  2. At what point will you break even?
  3. What are the bottom line net margins (EBITDA)?

Those questions are NOT disclosed fully in the FDD, because the federal trade commission does not REQUIRE this information in what is called item 19 of the document.  There will hopefully be some partial disclosures, but not full disclosure.  This is partly because in every system there are differences in the way individual owners run their books.  And partly because these franchises have attorneys – who recommend to their franchise clients that they don’t do anything that could open themselves up for lawsuits.  And given that full EBITDA disclosures of ALL franchisees in the system is not industry standard (and frankly not practical to gather data for) the obvious legal recommendation is not to do so.

So how do you adequately discover this information?  By a process called validation, which is simply calling numerous franchisees in the system and asking them!  They are allowed to tell you anything, and most of them are happy to do so.  The contact information for all current franchisees is required to be disclosed in the FDD – as well as those that have left the system in the last three years!  So it’s easy but time consuming, and the most important step that should never be skipped.

Here are a few starter questions

  • What is your annual gross revenue?
  • How did your initial investment compare to the franchisor’s estimates?
  • What’s your favorite part of the business?
  • What are some struggles you’ve faced or that you currently face in the business?
  • Have you started to cash flow?  How long did that take?
  • Do you feel like you made a good investment?  Would you advise your friends and family to invest in this business?
  • Do you feel you are getting “bang from your buck” with the marketing fees?

There are hundreds of similar questions you can (and should!) ask.  You and your franchise consultant can brainstorm a good list given the brand you are researching.  Interview as many franchisees – and former franchisees – as you need to feel comfortable.  Remember, if it doesn’t feel right, this may not be the franchise for you!

Qualitative Due Diligence

Equally as important as profitability and functionality is the culture of the franchise.  Digging into the culture of a potential franchise will help give you an idea if you could be happy running it.  When all is said and done, you want to make a sound investment and run your own business on your own time – but you need to be happy doing it!

 

This article was contributed to the National Franchise Institute by Jane Stein, Franchise Broker with Your Franchise Is Waiting     (303) 859-9317

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