Evaluate Franchise Opportunities Carefully

July 20, 2009

A franchise business may provide an excellent opportunity for an entrepreneur. Whether a restaurant, dry cleaner, health club, tax preparer or any number of other opportunities, a franchise offers the potential business owner significant advantages. Many franchisors have built a successful business, packaged the formula for running that business and developed name recognition. Franchisors may provide training programs, and offer ongoing mentoring and support. Additionally, a franchise business can offer access to economies of scale and cooperative advertising not available to an independent business owner. Of course, there are costs to obtain all of these advantages, which are described below.

No one should enter into a franchise agreement with the expectation that they will get an evenly drafted contract. Most franchise agreements are extremely one-sided in favor of the franchisor. When investigating an opportunity, it is important to fully understand the costs and the benefits of entering into a particular franchise agreement.

What Information is Available when Researching Opportunities?
The Federal Trade Commission requires that a franchisor provide a “franchise disclosure statement” at the request of a potential franchisee. A potential franchisee has the right to receive this statement at least 14 days before being asked to pay any money or enter into a franchise agreement. This statement contains a number of important pieces of information that can help a potential franchisee determine if the franchise opportunity is right for them.

The franchise disclosure statement should spell out the risks factors and costs associated with the franchise. It will also provide background information on the franchisor, identifying key personnel and including their business background. This statement should also clearly indicate the franchisor’s litigation or bankruptcy history. Other topics covered include:

  • How intellectual property may be used
  • Training
  • Advertising
  • Terminations

The franchise disclosure statement also must include some financial information, specifically the franchisor’s balance sheet from the past two years.

Another important document that a potential franchisee should request is an “earning claims statement.” This statement includes actual, average, projected or forecasted franchise sales, profits or earnings. Although the franchisor is not required to provide this; a franchisor declining to provide one should raise a red flag and may suggest that more research is necessary. If a franchisor does provide an earning claims statement, review it carefully as it may be misleading. While franchisors must base their financial disclosures on reasonable claims, they will provide numbers that present the potential of their franchising opportunities in the best light. Look at the sample size, geography and overall market of the franchisees used to support the earnings statement. A potential franchisee should attempt to realistically compare and adapt those numbers to the opportunity that is available.

Reviewing the Franchise Agreement
Each franchise agreement will be unique to the franchising opportunity. Factors, such as the type of business, location, experience of the franchisor and the franchisee, and numerous others will affect what is included in a particular franchise agreement. After researching opportunities and selecting one, review and understand the unique franchising agreement associated with that franchise.

The franchise agreement will provide the terms of the relationship, laying out the obligations of both the franchisee and the franchisor. The agreement should specifically describe the territory assigned to the franchisee, as well as whether the franchisee has exclusive rights within that territory. The agreement should also express the duration of the franchising relationship, and what renewal rights are available. Renewal rights are not necessarily guaranteed. The termination and cancellation policies, and resale rights included in the agreement will have a large affect on the franchisee’s risks. If a franchise is terminated or cancelled, a franchisee may lose its investment.

The obligations of a franchisee will include the fees that must be paid. These fees generally are an initial up-front franchise fee and a royalty fee consisting of a percentage of gross sales, which is paid monthly. Franchising agreements will also describe any additional expenses, such as training fees or cooperative advertising fees.

Other franchisee obligations may include a commitment to adhere to standard operating protocol developed by the franchisor. The franchisor has a strong desire to ensure that every franchisee provides a consistent product associated with the brand. Therefore, the franchisor will likely require adherence to an operator’s manual for everything from site selection, signage and design, to business systems and software used. The franchisor may also require that items be leased or purchased from designated sources. This type of provision requires a franchisee to purchase or lease from a vendor even if the franchisee could more efficiently purchase or lease from somewhere else.

The agreement may also contain any number of additional obligations for franchisees. Confidentiality agreements and non-competition clauses are common. Some franchisors also require active management by the franchisee.

The franchise agreement will also contain the franchisor’s obligations. The franchisor’s commitments often include advertising and marketing, training, and mentoring or supervision. The franchisor may also provide assistance in finding appropriate locations or site development. The terms will also include licensing the use of trademarks, patents, signage and other intellectual property held exclusively by the franchisor.

Other Steps to Take Before Entering Into a Franchise Agreement Talking with existing franchisees may provide valuable information. Existing franchisees or franchisees that have recently left the system are often the most reliable source of information to verify the franchisor’s claims. Existing franchisees may also have advice on dealing with that particular franchisor, and can share their experiences in running a franchise in the system.

While individual franchisees may not have equal bargaining power, consider what terms in the franchise agreement may be negotiated. In almost every franchise agreement, there are terms that are negotiable. This is especially true if the franchisor is not yet a well-established brand. While a franchisor with an iconic, national brand is unlikely to be willing to negotiate the major terms in its standard franchise agreement, a franchisor starting out may be more willing to negotiate significant terms. Additionally, while some terms such as trademark usage or adherence to the operations manual are not often negotiable, other terms may be, such as the number of managers the franchisor agrees to train or territorial exclusivity.

A franchise can provide an excellent opportunity for an entrepreneur, particularly if the franchisor has developed a successful business, and has packaged the formula for running it. Owning a franchise business can allow the franchisee to tap into brand recognition and economies of scale that an independent business owner would not have access to. These advantages do come with a cost and it is important that a potential franchisee fully understand the obligations and risks associated with entering any specific franchise agreement. From investigating potential businesses, through negotiating a franchising agreement and beyond, understanding the opportunities available to a franchisee is vital to realizing the goal of being a successful business owner.

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For more information about "Evaluate Franchise Opportunities Carefully," contact Larry K. Libman at llibman@axley.com or 608.283.6727.