7 Due Diligence Tips For Future Franchisees

(This is a guest post from Jeff Fabian, Attorney.) 

Most people considering purchasing a franchise have at least heard that they need to perform “due diligence” on the franchise opportunity. However, many people do not know what an appropriate due diligence investigation entails. This article discusses seven key components of the due diligence process – to the exclusion of many others. By addressing these and other issues, prospective franchisees can better position themselves for long-term success with their chosen franchise opportunity.

1. Speak with Current and Former Franchisees

One of the most important components of any due diligence investigation is to speak with the franchisor’s current and former franchisees. Some franchisors will have lists of their “recommended” franchisees that they provide to prospects and suggest that they get in touch with. These franchisees are often “recommended” for a reason—they are the best-performing and most satisfied franchisees in the system. As a result, franchise candidates need to go beyond the franchisor’s recommendations, and independently contact a large portion of the current and former franchisees listed in Item 20 of the franchisor’s Franchise Disclosure Document (FDD).

Current and former franchisees can provide a wealth of information that will help inform a decision regarding a potential franchise investment. In certain circumstances, one or more former franchisees may be able to tell you all you need to know to avoid a debacle of an investment.

Of course, new concepts and geographically-focused concepts may have no or only a limited number of franchisees. These opportunities should not simply be avoided wholesale; however, in these cases it will be particularly important to have candid and open discussions with the franchisor’s owners and representatives.

2. Perform Comparative Research

Many times, prospective franchisees will mentally commit to one particular franchise opportunity before doing their research on the franchise system, and without meaningfully considering any other franchise opportunities. This generally is not a recommended course of action.

As with any significant investment or business opportunity, prospective franchisees should at least consider some comparable franchise opportunities. This comparative analysis will shed light on unique aspects of different systems, expose departures from industry standards, and generally provide further insight for making an informed final decision about the franchise to be pursued.

Any additional information that prospective franchisees can obtain to help inform their decision whether or not to pursue a particular franchise opportunity will be well worth the investment.

3. Perform Your Own Investigation of the Estimated Initial Investment

In Item 7 of the FDD, franchisors are required to disclose high and low estimates for the total initial investment required to open a franchised outlet and get through the first three months’ worth of operations. Some franchisors do a better job of providing accurate estimates than others, but in any case it is important for all franchise candidates to perform their own independent research and calculations to determine their own anticipated initial investment.

Rent, licensing and permit fees (where applicable), and employee wages are just a few of the core Item 7 line items that can vary substantially from one location to the next. There is a wealth of resources available to assist prospective franchisees in informing themselves about the costs of running a business in their specific geographic and demographic locale, and prospective franchisees should use these to their advantage.

4. Recognize the Role of Franchise Salespeople and Franchise Brokers

It is important to remember that, while the franchise relationship is to an extent a symbiotic relationship that relies on the franchisee’s ability to succeed, franchising itself is still a business, and so franchisors (some to a greater extent than others) will try to “sell” you to get you into their system. Most franchise sales pitches, like any others, will focus on the benefits of the system to the exclusion of its risks and limitations.

The same holds true for the motives of many (but certainly not all) franchise brokers. Franchise brokers have portfolios of franchisors that they represent (and from whom they receive commissions), and as a result they may be tempted to steer prospects to these particular franchise opportunities to the exclusion of others that may be a better fit.

As a result, when working with internal sales staff, prospective franchisees should still seek access to operations personnel and the sales staff should be knowledgeable about basic franchise disclosure regulations and the basic terms of the franchise agreement. Similarly, when working with a franchise broker, prospective franchisees should seek out information as to how many and which franchisors the broker works with, and how the broker is compensated by these franchisors. In any case, the process should be reasonably transparent, and pushy sales tactics and signs or suggestions that information is being withheld should raise red flags.

5. Consider What You Want Long-Term from the Franchise Opportunity

It is important for all franchise candidates to remember that one aspect that makes a franchise very different from an independent small business is that most come with a 5-year, 10-year or longer binding contractual obligation to run the business, pay royalties, and comply with the franchisor’s standards and specifications. Ways out can be negotiated with some franchisors, and sale is generally an option if the business is successful, but generally franchisees cannot simply decide to move on if they get bored, or unhappy or unsuccessful. Closing up shop carries the risks of owing liquidated damages or “lost future royalties” to the franchisor (not to mention unpaid rent due under the lease), and may well entail competitive restrictions and other post-termination obligations.

Prospective franchisees need to keep these realities front and center when considering new franchise opportunities. That “hot” concept may not look so attractive if you are not personally invested in the concept and it comes with heavy post-termination payment obligations saddled by a personal guaranty.

6. Rely on Experience

One thing franchise prospects need to keep in mind is that there will always be someone out there with relevant knowledge and experience who can help guide you on your way. Even if you are experienced in developing and running a new business, franchising has its own unique intricacies that countless lawyers, accountants, consultants and other franchisees have already dealt with before your time. Individuals considering franchise opportunities should rely on these people for their experience and expertise. Doing so will help them hit the ground running in the best position possible to succeed under the franchise model.

7. Understand and Negotiate the Franchise Agreement

Finally, I see this less and less as time progresses, but some franchisors will still claim that they are “not allowed” to negotiate the franchise agreement. This antiquated notion is simply not true, and prospective franchisees should indeed attempt to engage in active and realistic negotiations with their franchisor in light of industry, system, experience, economic and other factors.

Because of the long-term and binding nature of the franchise relationship, it is absolutely crucial for franchise prospects to understand the terms of their franchise agreement, and attempt to negotiate appropriate concessions to reasonably protect their interests over the long haul. While certain provisions will understandably be deemed non-negotiable, on the whole prospective franchisees with experienced counsel should be able to negotiate reasonable modifications that limit their risk exposure and enhance their overall chances for success.

Understanding and negotiating the franchise agreement are fundamental tasks for any entrepreneur – or individual in a career transition – considering a new franchise opportunity.

This article is provided for informational purposes only, and does not constitute legal advice.

Jeff Fabian is the owner of Fabian, LLC, a boutique law firm that represents prospective franchisees in performing due diligence and negotiating franchise agreements nationwide. Visit www.fabianlegal.com for more information, or follow Jeff on Twitter @jsfabian.