5. Investigating Before You Invest

The All-Important Disclosure Document

Before you invest in any franchise system, get a copy of the franchisor’s disclosure document. Under the Franchise Rule, which is enforced by the FTC, you must receive the document at least 14 days before you are asked to sign any contract or pay any money to the franchisor or an affiliate of the franchisor. You have the right to ask for—and get—a copy of the disclosure document once the franchisor has received your application and agreed to consider it. Indeed, you may want to get a copy of the franchisor’s disclosure document before incurring any expenses to investigate the franchise offering.

The franchisor may give you a copy of its disclosure document on paper, via email, through a web page, or on a disc. The cover of the disclosure document should have information about its availability in other formats. Make sure you have a copy of the document in a format that is convenient for you, and keep a copy for reference.

Read the entire disclosure document. Don’t be shy about asking for explanations, clarifications, and answers to your questions before you invest. Among the key sections in a complete disclosure document are:

Franchisor’s Background

This section tells how long the franchisor has been in business, likely competition, and any special laws that pertain to the industry, like any license or permit requirements. This will help you understand the costs and risks you are likely to take on if you purchase and operate the franchise.

Read the entire disclosure document. Don’t be shy about asking for explanations, clarifications, and answers to your questions before you invest.

Business Background

This section identifies the executives of the franchise system and describes their experience. Pay attention to their general business backgrounds, their experience in managing a franchise system, and how long they’ve been with the company.

Litigation History

This section discusses prior litigation—whether the franchisor or any of its executive officers have been convicted of felonies involving fraud, violations of franchise law, or unfair or deceptive practices law, or are subject to any state or federal injunctions involving similar misconduct. It also says whether the franchisor or any of its executives have been held liable for—or settled civil actions involving—the franchise relationship. A number of claims against the franchisor may indicate that it has not performed according to its agreements, or, at the very least, that franchisees have been dissatisfied with its performance.

This section also should say whether the franchisor has sued any of its franchisees during the last year, a disclosure that may indicate common types of problems in the franchise system. For example, a franchisor may sue franchisees for failing to pay royalties, which could indicate that franchisees are unsuccessful, and therefore, unable or unwilling to make their royalty payments.

Bankruptcy

This section discloses whether the franchisor or any of its executives have been involved in a recent bankruptcy, information that can help you assess the franchisor’s financial stability and whether the company is capable of delivering the support services it promises.

Initial and Ongoing Costs

This section describes the costs involved in starting and operating a franchise, including deposits or franchise fees that may be non-refundable, and costs for initial inventory, signs, equipment, leases, or rentals. It also explains ongoing costs, like royalties and advertising fees. In addition, ask about:

Continuing royalty payments
Advertising payments, both to local and national advertising funds
Grand opening or other initial business promotions
Business or operating licenses
Product or service supply costs
Real estate and leasehold improvements
Discretionary equipment, such as a computer system or a security system
Training
Legal fees
Financial and accounting advice
Insurance
The costs of compliance with local ordinances, such as zoning, waste removal, and fire and other safety codes
Health insurance
Employee salaries and benefits

Starting your business may take several months. Estimate your operating expenses for the first year and your personal living expenses for up to two years. Compare your estimates with what other franchisees have paid and with competing franchise systems. You may be able to get a better deal with another franchisor.An accountant can help you evaluate this information.

Restrictions

This section tells whether the franchisor limits:

Suppliers from whom you may purchase goods
The goods or services you may offer for sale
Your customers
Where you can sell goods or services
Your use of the Internet to sell goods or services to customers in and out of your territory and the right of the franchisor (or other franchisees) to use the Internet to solicit customers or to sell in your territory

These kinds of restrictions may limit your ability to exercise your own business judgment in operating your outlet. That said, if the franchisor does not limit the territory where each franchisee can sell, the franchisor and other franchisees may compete with you for the same customers, either by establishing their own outlets, or by selling to customers in your area through the Internet, catalogs, telemarketing, and the like.

Terminations

This section spells out the conditions under which the franchisor may end your franchise and your obligations to the franchisor after termination. It also defines the conditions under which you can renew, sell, or assign your franchise to others.

Training

This section explains the franchisor’s training and assistance program. Check for information about:

Who is eligible for training
Whether new employees are eligible for training and, if so, at what cost. Who pays?
How long the training sessions take. How much time is spent on technical training, business management training, and marketing?
Who conducts the training and their qualifications
Whether the company offers ongoing training and at what cost
Support staff available for trouble-shooting: Are they assigned to your area and how many franchisees they are responsible for?
Whether on-site individual assistance is available and at what cost

The training you need will depend on your business experience and your knowledge of the franchisor’s goods and services. If you have doubts about whether the training offered is sufficient to give you the tools you need to handle day-to-day business operations, consider another franchise opportunity.

Advertising

This section has information on advertising costs. Franchisees often are required to contribute a percentage of their income to an advertising fund. Find out:

What part of the advertising fund is devoted to administrative costs
What other expenses are paid from the advertising fund
Whether franchisees have any control over how the advertising dollars are spent
What advertising promotions the company has already engaged in and what’s on the drawing board
What percentage of the fund is spent on national advertising
What percentage of the fund is spent on advertising in your area
What percentage is devoted to selling more franchises
Whether all franchisees contribute equally to the advertising fund
Whether you need the franchisor’s consent to develop and buy your own advertising
Whether there are rebates or advertising contribution discounts if you do your own advertising
Whether the franchisor gets any commissions or rebates when it places advertisements, and who benefits from those—you or the franchisor

Current and Former Franchisees

This section has very important information about current and former franchisees. Many franchisees in your area may mean more competition for customers. The number of terminated, cancelled, or non-renewed franchises may indicate problems.

Some companies may repurchase failed outlets and list them as company-owned outlets.

Look for contact information for current franchisees and franchisees who have left the system within the last year; talking to them may be the most reliable way for you to verify the franchisor’s claims. Visit or phone as many of the current and former franchisees as possible to chat about their experiences, and the volume and type of business they’re doing. Note that some of them may have signed confidentiality agreements that prevent them from speaking with you. If that’s the case, try contacting others on the list.

If you buy an existing outlet that was reacquired by the franchisor, the franchisor must tell you who owned and operated the outlet for the last five years. Several owners in a short time may indicate that the location isn’t profitable or that the franchisor hasn’t supported that outlet as promised. Consider contacting several previous owners to learn more about their experience operating the particular outlet. You will want to learn:

How long the franchisee operated the franchise
Where the franchise was located
Whether they were able to open the outlet in a reasonable time
Their total investment, including any hidden or unexpected costs
How long it took them to cover operating costs and earn a reasonable income
Whether they were satisfied with the cost, delivery, and quality of the goods or services they sold
Their backgrounds before becoming a franchisee
If you have doubts about whether the training offered is sufficient to give you the tools you need to handle day-to-day business operations, consider another franchise opportunity.
Whether the franchisor’s training was adequate
Whether the franchisor provided ongoing help
Their satisfaction with the franchisor’s advertising program
Whether the franchisor fulfilled its contractual obligations
Whether the franchisee would invest in another outlet
Whether the franchisee would recommend the investment

Some franchisors may give you a separate reference list of franchisees to contact. To ensure that you get the full picture, you may want to contact at least some references listed in the disclosure document that are not on the separate list.

Associations of Franchisees Operating Similar Outlets

There’s no question that the disclosure document is critical reading for potential franchisees. Associations of franchisees who are operating similar outlets are another important source of information. Whether or not these associations are sponsored or endorsed by the franchisor, they can provide information about the state of the relationship between the franchisor and its franchisees. You may want to ask a franchisee association about:

Its membership
Its history
Its goals
Iits relationship with the franchisor
Any benefits in buying from one franchisor versus a competitor
Any problems franchisees are facing in the operation of their outlets

Earnings Information

You may want to know how much money you can make if you invest in a particular franchise system. Be careful. Earnings information can be misleading. Insist on written substantiation for any information you may receive that suggests your potential income or sales.

Franchisors are not required to disclose information about potential income or sales, but if they do, the law requires that they have a reasonable basis for their claims and that they make the substantiation for their claims available to you. When you review any earnings claims, consider sample size. Say a franchisor claims that franchisees in its system earned $50,000 last year. The claim may be deceptive if it doesn’t represent the typical earnings of franchisees. The disclosure document should tell the sample size and the number and percentage of franchisees who reported earnings at the level claimed.

Average Incomes

A franchisor may claim that the franchisees in its system earn an average income of, say, $75,000 a year. Average figures tell very little about how individual franchisees perform. An average figure may make the overall franchise system look more successful than it is because just a few very successful franchisees can inflate the average.

Gross Sales

Some franchisors provide figures for the gross sales revenues of their franchisees. These figures don’t really tell about the franchisees’actual costs or profits. An outlet with a high gross sales revenue on paper may be losing money because of high overhead, rent, and other expenses.

Net Profits

Franchisors often do not have data on net profits oftheir franchisees. If you get net profit information, ask whether it includes information about company- owned outlets; they often have lower costs because they can buy equipment, inventory, and other items in larger quantities, or they may own, rather than lease, their property.

Geographic Relevance

Earnings may vary with geography. If it’s reported that a franchisee earned a particular income, ask about the franchisee’s location. The disclosure document should note geographic or other differences among the group of franchisees whose earnings are reported and your likely location.

Franchisees’ Backgrounds

Keep in mind that franchisees have different skill sets and educational backgrounds. The success of some franchisees doesn’t guarantee success for all.

Reliance on Earnings Claims

Franchisors may ask you to sign a statement— sometimes presented as a written interview or questionnaire—that asks whether you received any earnings or financial performance representations during the course of buying a franchise. If you heard or got any earnings representations, report it fully during an interview or on a questionnaire or other statement. If you don’t, you may be waiving any right to contest the earnings representations that were made to you and that you used to make your decision to buy.

Financial History

The disclosure document gives important information about the company’s financial status, including audited financial statements. You can find explanatory information about the franchisor’s financial status in notes to the financial statements. Investing in a financially unstable franchisor is a significant risk; the company may go out of business or into bankruptcy after you have invested your money.

It’s a good idea to hire a lawyer or an accountant to review the franchisor’s financial statements, audit report, and notes. They can help you understand whether the franchisor:

Has steady growth
Has a growth plan
Makes most of its income from the sale of franchises or from continuing royalties
Devotes sufficient funds to support its franchise system