Investing In A Franchise: Assessment Difficulties

A prospective franchisee is faced with the responsibility of doing a great deal of research before deciding on investing in a franchise. Many believe due diligence is satisfied …

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A prospective franchisee is faced with the responsibility of doing a great deal of research before deciding on investing in a franchise. Many believe due diligence is satisfied by carefully reviewing the franchise disclosure document (FDD); however, experts warn that these agreements are not monitored by any type of oversight agency and can easily be crafted to put the franchisee at a disadvantage. Franchise specialists agree that the FDD can be tweaked or left incomplete, and that anyone interested in investing in a franchise should seek outside sources of information before closing the deal. For more on this continue reading the following article from Blue MauMau.

The Wall Street Journal, in an insightful article, writes that if you are thinking about investing in a franchise, make sure that you read the franchise disclosure document and speak with franchisees.   It goes on: "Most of what you need to make an informed decision about a franchise system is readily available. Franchisers are required by federal law to provide prospective buyers with disclosure documents at least 14 days prior to a sale."

That sounds as if speaking with franchisees and poring through a disclosure document is largely sufficient to determine a franchise opportunity. What’s the truth?

At Blue MauMau, we take joy in deeply exploring these complex issues of franchising. So we have asked the same franchise experts in the article — and then some — to expound.

BMM: Is most of what is needed to make an informed investment decision really disclosed in the franchise disclosure document? How much can the franchisor’s statements in the FDD be relied on?

The disclosure document isn’t monitored by any government agency. The information it contains is on an honor system. Complicating matters, its system-wide information is often difficult for an individual franchisee, who just knows their own business, to disprove. So is the franchise disclosure document information sufficient to make an informed investment or is it a marketing brochure meant to attract franchise buyers which has the veneer of officialism?

Summary of experts: The franchise disclosure document is only the beginning of the process. Its information can be wrong and misleading, but it can be a tool to cross-check and see how forthcoming and honest the franchisor is.

Attorney Justin Klein of New Jersey-based law firm Marks & Klein behind such recent lawsuits of a $206 million Quiznos settlement and a much-watched lawsuit of a  franchisee association against Edible Arrangements says:

Reviewing the Franchise Disclosure Document is certainly not the end of the process, it is merely the beginning. Presumably, by the time an FDD is received, a franchisee prospect has exhausted his or her ‘preliminary’ investigative efforts in narrowing the choices of potential franchise investments. That is, potential franchises have been identified and the prospect has likely reviewed the Zor’s website, tried the product or service and perhaps even spoken to the owner of a local unit. The FDD provides answers to numerous basic questions – unfortunately, those answers may be wholly irrelevant to the specific prospect’s actual anticipated experience.

The FDD is filled with information. However, that information is typically estimates and averages hypothesized by principals of the franchisor or even worse, the franchisor’s lawyers or advisors, who may not have any practical experience in the operation of the business. The prospect must then rely on these guesstimates and apply them to their own circumstances. For example, the initial estimated investment may be based on 1,800 square foot locations throughout New Mexico while the franchisee prospect might be intending to operate a 2,500 square foot location in Ohio. Point is, the FDD should be and is the logical starting point for any franchisee in the due diligence process. But, any prospect that stops there is doing themselves a terrible disservice.

The franchisee prospect should use the information in the FDD as a guideline – use the information to gather information about the system that is not readily available in the public forum such as the franchisor’s financials. This will help analyze the financial health of the system. The franchisee prospect should use the information in the FDD to cross check the veracity of the information in the disclosure by speaking with franchisee’s in the system or those that have already exited the system. Lastly, the FDD should be used to help the Zee prospect formulate additional inquiries about how the system works, how the franchisor makes its money and to better understand what are the expectations of the franchisees in the system – financially and operationally. The FDD should be reliable, accurate and complete. Caution, however, many a franchisor merely disclose only what they believe the law requires and fall short of disclosing material information that may have otherwise influenced a prospect’s decision to avoid the investment. Most importantly, franchisee prospects should not do it alone. The franchisee needs to build a reliable team around them to help through the due diligence process including at the very least reviewing the FDD. Lawyer, accountant, business advisors all need to be on the team.

Researcher Jeff Johnson, president of Franchise Research Institute says:

During my 28 years in franchising (as a multi-unit franchisee, area developer, and researcher) I can state without hesitation that the FDD is far from an all-inclusive picture of a franchise opportunity. Not only can negative information be omitted, but the facts can be "tweaked" in a manner which is very deceiving to the franchisee prospect. However, the franchise’s legal contracts must be thoroughly reviewed, as a part of the due diligence process. They tell another critical part of the company’s "story."

What the FDD does not outline (and typically, neither do marketing brochures) are the specific issues which lead to franchisee satisfaction, such as opening support, ongoing training, effectiveness of communication with the franchisor, new product and/or service introductions, etc. The level at which the franchisor is committed to franchisee success is also critical. This is the sort of information which gives a much better "behind the scenes" picture of what is actually happening within a franchise system.

Attorney Mario Herman of Washington D.C. says:

The information in a Franchise Disclosure Document is mainly reliable but it is only a starting point. 

I would especially make sure to investigate Item 20 (attrition rate) and Item 3 (prior litigation).  Sometimes unscrupulous franchisors fudge these sections to make themselves look better.  In addition, Item 19 (financial performance or "earnings claims") can be misleading. 

There is an old saying by Mark Twain — "There are liars, damn liars, and then statisticians."  I would double check the figure with current and former franchisees.  Start from the perspective that a franchisor will color items in the FDD to make itself look better in the eyes of a prospective franchisee. 

Do not accept it as Gospel.

What do you make of franchise earnings claims in the FDD?

Most franchisors still elect to not release average unit earnings in the disclosure document. According to Robert Bond of Bond’s Publishing, a market research firm that carefully scrutinizes disclosure documents, some 60 percent of franchisors do not declare any sort of unit earnings representations.

Summary of experts: If a franchisor doesn’t reveal at least average unit earnings in the disclosure document, walk away. Anyone looking at investing in a franchise needs to know earnings in order to ascertain a reasonable expectation of return on investment.

Justin KleinJustin Klein: Franchisee prospects should pay close attention to financial performance representations ("FPR") in the FDD. Unfortunately, not enough franchisors make this disclosure in the FDD. Be wary of any franchisor that does not make a financial performance representation [for an average franchise unit]. This warning is even more important if the target franchise has been offering franchises for several years or has a significant amount of locations/franchisees. In that circumstance, the inference can be drawn that the absence of an FPR can only mean that the statistics are not that good. Even if untrue, the absence of and FPR leaves the prospect with little ability to conclude otherwise. Additionally, even if an FPR is made, again, that information is only as relevant as it applies to the prospect’s situation. The FPR should not be used to create expectations of potential returns – rather, it should be used to keep those expectations level. Use the FPR to get an understanding of what others in the system may be doing, but again, you may do better and you may do worse. Finally, it is necessary to test the FPR against your own market research to forecast what you may be able to do in your location. That is, compare your projected costs and revenues with those in the FPR (if identified) to ascertain projected profit levels and other financial markers.

Jeff JohnsonJeff Johnson: It has been my experience that a number of high-quality franchise opportunities do not include earnings claims as part of their FDD. Earnings are the result of gross sales minus expenses; something that can be incredibly variable from one owner to another.

Anyone considering the purchase of a franchise needs to have an accurate picture of return on investment. ROI is not just about net income, but is the amount of return on the composite of time AND money invested. It is critically important to consider the amount of time a franchisee is expected to commit in order to earn the expected net income. There are some franchise companies which allow an individual to make a very comfortable income, while working from home, and maintaining a family-friendly lifestyle. Others may require 80+ hour work weeks and significant, long-term financial commitments, with a net income which is at subsistence-level or below. From this perspective, an acceptable ROI is highly individual.

Mario Herman Mario Herman: I do not think there is any reason not to provide earnings information, unless a franchisor is a brand new one with no track record. It should be mandated.

The only reason a franchisor does not provide unit financial performance information is because it is uncomfortable with the level of earnings. It is the most important question a prospect wants answered ("How much money am I going to make?"), and it is the one that is frequently misleading or deceptive.

Franchisors range from stating disinformation to a prospect that it is illegal to giving earnings claims (Not!), to stating that franchisees do not report them accurately (frequently not true). I would not trust a franchisor that did not provide earnings information. It is simply inexcusable, and should not be countenanced.

What are the best ways to get the inside scoop, the "dirty laundry" about a franchise system?

Critics say that franchisees can be pressured to portray a favorable picture of a franchise chain, while suppressing the unflattering. That’s because if franchisees say something bad about their franchisor, there can be disastrous repercussions. Their permission to expand units might mysteriously be withdrawn. Or they might be found surprisingly wanting in their next inspection by the franchisor and be abruptly terminated from the network without even being able to sell their business to recover some of their costs.

Summary of experts: Franchisees are wary of revealing the "dirty laundry" of a franchise system. One expert says an anonymously well-done satisfaction survey can get around this problem and can gauge general  franchisee satisfaction. Experts say ask former franchisees. But one expert says the problem is that they are old news. Pore through the Internet for candid comments and use experts to navigate through the morass.

Justin KleinJustin Klein: Many systems have no dirty laundry to air. Unfortunately, some do.

The most effective way to ascertain the details that certainly will not be in the FDD, is to speak to franchisees currently in the system and those that have exited. Of course, the information learned must be taken with a grain of salt in either case, but the more franchisees that one speaks with, the greater likelihood the truth will be learned. A prospect can likely learn, for example, how well the training program is executed and how the franchisor handles operational or customer service concerns, issues or problems. Additionally, franchisee prospects should seek out franchisee associations within the system and speak with the representatives to inquire about issues that may exist within the system.

Lastly, and perhaps most importantly, the franchisee prospect should scour the Internet to see if there is media, blogs, chat rooms, or worse, websites dedicated to misdeeds of the franchisor or commentary of unhappy franchisees. The Internet is probably the most important tool (along with a team of experienced professionals) that must be utilized in the due diligence process to learn as much about the franchisor as possible – the good, the bad and the ugly.

Jeff JohnsonJeff Johnson: My research company was founded on the principle that the best way to determine if a franchise opportunity is worth considering is to evaluate the satisfaction of the system’s existing franchisees. Franchisee satisfaction is a measurement of the degree to which a franchise company is able to meet or exceed the expectations of the individuals they attract and "sign on" to their system. I steadfastly maintain that the ONLY way to accurately obtain this information is to contact EVERY franchisee (including those who have been in the system a short time, and those who have not yet opened locations). The franchisees must be assured complete confidentiality, in order to eliminate "false positive" responses, out of either fear or a desire to garner favor with the franchisor. Former franchisees (who have exited the system) may have had personal issues which do not necessarily reflect the current franchisee’s reality.

It is not reasonable or fair to expect 100% satisfaction. It is truly impossible to please all of the people, all of the time; however, the notion that a system with 50% franchisee satisfaction is going to be a wise investment is unsound.

It is unrealistic (if not impossible) for an individual considering the purchase of a franchise to contact a broad enough number of existing owners, and difficult for them to know the appropriate questions to ask. Essentially, "you don’t know what you don’t know." That is why looking at published, third-party research on top-quality franchise opportunities is extremely beneficial. That said, not every franchise has gone through the scrutiny of this process, and certainly, many are (understandably) afraid or unwilling to do so. Also, there is survey data available which does not meet the criteria of independent validation, or of complete inclusion and confidentiality. Once again, it falls on the prospective franchisee to be a "wise consumer" of ALL information available on the investment they are considering. Our focus has not been on seeking out "dirty laundry," (although there is plenty in franchising), but rather on excellence and transparency in franchising.

Mario HermanMario Herman: Current franchisees are afraid that the prospect calling is a mole for Corporate [the franchising firm]. Former franchisees believe the same, and frequently have non-disclosure agreements they have to abide by. Also, it is human nature not to share confidential, private, financial information with a stranger on the phone. How many times do you go up to someone in an elevator that you have never met and ask him how much does he or she earn? There is a built-in reluctance to share.

It is also difficult to gain access to former franchisees as contact information (provided in the FDD) changes over time.

As part of due diligence, a prospect should search thoroughly the Internet and look for both positive and negative listings on the franchise.

I believe former franchise owners generally are more inclined to tell you the truth regarding their return on investment (ROI). Search out and focus your inquiry on them, but do not ignore existing ones. Just do not go to the hand picked ones the franchisor tells you to call. You will get a very one-sided (pro-franchisor) picture, which will not reflect the financial reality.

Make sure also that the earnings information provided is geographically applicable to your area of the country, and that the socio-economic information is comparable. Distinctions such as urban, suburban, and rural are also important. Rent and labor factors vary considerably as well.

 

This article was republished with permission from BlueMauMau.

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