Many budding entrepreneurs have dreams of being a franchisee. Opening a business that already has an established brand and positive reputation seems like a better way to assure success instead of attempting to start a business from scratch. This may be true but a franchise costs considerably more than starting your own business in most cases so proper due diligence at the beginning stages is a must.
The first thing you must do is get a copy of the Franchise Disclosure Document (FDD). This contains some key information in which to start your due diligence. Often, you’ll have to answer some basic questions before the franchisor will provide this to you but this can be done online in most cases.
Once you have a copy of the FDD, here are the key places to look:
Line 20: Unit Counts
Is the amount of franchisees growing, staying the same, or declining. This is a key metric that will tell you if people who operate a store are making money or not. If the number of units is declining, this is a major red flag. In the investing world, the basic rule is not to fight the trend and if the trend is declining, you don’t want to be a part of this. Don’t accept any excuses or reasons that may be given for this.
Line 3: Litigation Experience
Nobody likes to lose and sometimes when they do, they head to court to try to recoup their losses. When a franchise isn’t producing winning results, franchisees head to court claiming breach of contract. If, during the course of your due diligence you see that line 3 is high and on the rise, this is another red flag.
A franchisor is required to supply audited financial statements for the past three years. You want to look at the cash flow and reserves. Positive cash flow and healthy cash reserves. This indicates that the franchisor has reserves in place in case something unexpected happens in the economy or with the company.
Same Store Sales
This might take a call to some franchisors. Make a few random calls and ask if their same store sales are increasing, decreasing, or staying flat? You don’t want to hear that sales are declining and staying flat may be ok for a year but this shouldn’t be a long term trend.
While you have them on the phone, complete your introductory due diligence by asking them if they would enter in to a franchise agreement with the company knowing what they know now. Often, you’ll notice a trend regardless of who you talk to.
Don’t listen to excuses. If the metrics don’t look good, move on. There are plenty of franchises that have positive metrics. Don’t take unnecessary risks. Due diligence only works if you act on the information you receive.