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Buying an existing franchise? Here’s Why you Need to Practice Due Diligence

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Thinking about buying a franchise? The decision is a big one, which is why it’s critical to carry out due diligence before rushing into the investment. With a better understanding of the business operations and finances of the franchise you’re interested in buying, you’ll know exactly what you’re getting into when you sign on the dotted line. Below, we’ll discuss some common franchise mistakes and the importance of due diligence so that you can avoid making those common mistakes and step into the role of franchise owner confident that you’ve done everything you can to ensure a wise investment.

What is Due Diligence

Due diligence is a complex process of investigating many areas of a prospective franchise. These areas may include finance, legal, operations, employee relations, customer data, and products. Generally speaking, due diligence will provide the following critical information:

  • Identify any potential purchase risks or liabilities 
  • Confirm the value of the franchise
  • Understand the operations and procedures of the business

A prospective buyer can use this information to make an informed decision about whether or not to buy a franchise. It’s also important to note that an experienced lawyer can help guide you significantly in this process. While you may find information important from a personal or business perspective, an experienced lawyer might find the information interesting from a legal perspective. 

Common Franchising Mistakes 

Some franchising mistakes are, unfortunately, common. A few that occur too often include:

  • Making decisions without all the necessary information
  • The franchisee or franchisor realizes they are not a good fit to conduct business together
  • Underestimating the investment
  • Not enough communication between franchisor and franchisee
  • Through due diligence, these mistakes can often be avoided. 

How to Practice Due Diligence When Buying a Franchise

The following is a list of due diligence tips prospective franchisees can take to ensure they have all the necessary information to make a well-informed and exciting decision to purchase a franchise. 

Basic Internet Search and Franchisor’s Website

This will often provide valuable information and takes little effort. Look for sites, like the Franchise Business Review’s Franchisee Satisfaction Reviews.  These reviews rely on honest feedback from real franchise owners and offer great insight into franchise businesses. 

It’s a place where franchisees and commentators can vent frustrations, be sure to address points raised with the franchisor. And if your franchisor is publicly traded, also check out EDGAR to find the franchisor’s quarterly and annual findings. 

Talk to Current and Former Franchisees

Ask questions. Lots of them. Franchisees, both current and former, provide valuable information. Discover their take on the franchise’s success, the support received from the franchisor, and why they decided to leave.

Compliance with the FTC Rule or other State Franchise Laws:

It’s not uncommon to find violations relating to registration or meeting disclosure requirements. Any violation may indicate problems. Finding out there are, in fact, problems, allows you to also find out how serious the problems are. If any violation is correctable, it might be a good idea to alert the franchisor. This can give valuable insight into how the franchisor handles the situation. If it’s a significant violation, a franchisee may want to walk away. 

Read the Finance Disclosure Document

Loaded with insider information, this document will provide you with everything you need to know regarding the franchisor and the business you’ll soon be operating. It provides the legal basis and lays out all the legal terms between the franchisor and the franchisee. It’s broken down into 23 items, each containing important information, and includes various exhibits. Make sure you understand key terms and every single section. A brief description of the franchise disclosure agreement can be found here, but in a nutshell, this is what you can expect to find:

  • Items #1-4: Background information, including any legal or bankruptcy issues
  • Items #5-7: Investment amount and any associated fees
  • Items #9-11: Franchisee’s obligations for running the franchise 
  • Item #10: Financing
  • Item #12: Territory
  • Item #13-14: Trademarks, Patents, Copyrights, Proprietary Information
  • Item #15: Obligation of franchisee to participate in the operation of franchise business
  • Item #16: Restriction on goods and services 
  • Item #17: Renewal, termination, repurchase, modification, and/or transfer of the agreement, dispute resolution
  • Item #18: Public figures
  • Item #19: Financial performance representations
  • Item #20: Charts that list outlets
  • Item #21: Franchisor Financial Statements
  • Item #22-23: Contracts/receipts

Review ALL Financial Documents

In order to thoroughly understand the financial situation, the following documents should be reviewed and understood:

  • The franchise’s general ledger
  • Schedules of accounts payable and accounts receivable
  • Schedule of all inventory/products and their value
  • Analysis of gross margins and fixed/variable expenses
  • Tax returns, including local, state, federal, and foreign tax returns for the last three years. Also, review any audit reports, tax settlement documents, tax liens, and employment tax filings
  • Any audited and unaudited statements, including reports, for the last three years
  • Franchise’s credit report
  • Projections, budgets and strategic plans
  • Information regarding debt, contingent liabilities, depreciation, and amortization methods

Verify Business Structure and Operations

This is important when determining the franchise’s potential earning potential. Take the opportunity to verify the franchise’s business model, products and/or services, customer base—including subscriber lists and sales records, and costs associated with labor, materials, and operations.  Additionally, you’re going to want to get your hands on the franchise’s following documents:

  • Articles of Incorporation, including amendments 
  • Any Bylaws, including amendments 
  • List of shareholders and share amounts for each
  • Any agreements relating to options, voting, warrants, puts, calls, subscriptions, and convertible securities
  • Secretary of State’s Certificate of Good Standing
  • All active status reports for the last three years
  • A list of physical assets, including U.C.C. filings, leases on equipment, and a schedule of sales and purchases of equipment for the past three years. 
  • A schedule of the franchise’s real estate locations, including copies of all leases, deeds, mortgages, title policies, and nay approvals or permits
  • Schedules of trademarks, trade names, copyrights, consulting agreements, and any claims regarding intellectual property by or against the franchise

Know When You’ll Recoup Investment

You’re investing a significant amount of money into the franchise. Be aware of the true cost of running the business and know when you can expect to reap the rewards. 

Have you factored in marketing, advertising, technology, etc.? Understand the cost to running your franchise. 

Get to Know Your Franchisor

Build a solid relationship from the very start. The franchisee is more likely to succeed when relying on accurate information from the franchisor, and a successful franchisee is in the best interests of the franchisor. 

Review Employee Information

Who are the key employees? Explore their payroll, tax, and benefits. This is important to know. And it’s also important to know which employees, if any, plan to leave after the company’s been sold. Specifically, make sure you review the following:

  • A list of all employees, including their positions, salaries, stock options, and any bonuses paid during the last three years
  • Any employment statements, including nondisclosure, non-solicitation or noncompetition
  • Resumés of employees
  • A description of any reports of employee wrongful termination, harassment or discrimination
  • A description of any employee lawsuits, arbitration requests, or complaints in the last three years
  • The personnel handbook, including lists of benefits and holiday, vacation, and sick leave policies
  • Any documents regarding retirement plans, insurance policies
  • Details regarding any labor disputes, arbitration, requests for arbitration, and current or pending grievance procedures settled within the last three years
  • A description of worker’s compensation and unemployment insurance claim history

Investigate pending claims and litigation history

Is there any pending litigation, threatened litigation, or unsatisfied judgments? Review insurance policies to investigate possible coverage pending or threatened litigation. Also, review any documents relating to injunctions or settlements where the franchisor is a party. 

Notice Warning Signs

Trust your research. Signs, such as a franchisor unwilling to answer questions or secrecy regarding any of the above tips, should not be ignored. 

Work with an Experienced Franchise Lawyer

Practicing due diligence when purchasing a franchise is always a good idea. But franchise contracts are complex and complicated, so consulting with an experienced franchise lawyer, especially if you’re a first-time buyer, is highly recommended. We’re here to help. Contact us to schedule a consultation.