The FTC’s Franchise Rule requires that every franchisor provide a Franchise Disclosure Document (FDD) to aid in due diligence. This document follows a standard, 23-section format, and you should always pay close attention to the content. It’s your primary, authoritative source for inside info on the franchise you’re considering. Hopefully, the FDD will boost your confidence in the franchisor, but it might contain some red flags. Here’s my Top 10 list of the scariest possibilities, in no particular order. If you run into any of these issues, it’s time to seriously reconsider doing business with the franchisor.
Lots of Lawsuits
Every FDD must list any previous or current litigation involving the franchisor or its leadership. Most businesses deal with a lawsuit or two at some point in their history. But a long list of lawsuits, either by or against the franchisor, could mean that the corporate office has a hard time getting along with franchisees and/or vendors. Frequent litigation can also drain a company financially, regardless of how the lawsuits resolve.
High Turnover
Your Franchise Disclosure Document will list all the franchises that have closed or transferred ownership in the last three years. A few closures or transfers are normal. People retire, have to move unexpectedly, or close a business for other innocent reasons. However, if this list is really long, that may be a sign of trouble. The franchisor may be growing too quickly, not providing enough support to franchisees, or even have a bad business system on its hands.
Inexperienced Leadership
Sometimes, it makes sense to sign on with a brand-new franchisor whose leadership team is franchising for the first time. At minimum, however, your FDD should show that the franchisor’s leadership have solid business experience as entrepreneurs or executives in other areas. A franchise’s value is in its proven success–that applies to the leaders as well as the business system.
Lack of Transparency
Since you haven’t officially become a franchisee yet, there will be some proprietary or confidential information the franchisor doesn’t disclose to you. However, due diligence should give you a sense that the franchisor is transparent with its franchisees. Proceed with caution if the language in the FDD seems deliberately opaque or if the franchisor stonewalls your questions, especially on a serious issue such as a past bankruptcy.
Financial Instability
Speaking of bankruptcy: the Franchise Disclosure Document must list any bankruptcies involving the franchisor or its leadership. A single personal bankruptcy (especially long ago) may not be a big deal, but a leadership team with a bankruptcy pattern is. And if the franchise itself has gone bankrupt, consider walking away. There are plenty of other good options with better financial histories.
No References
In the FDD, you should find a list of current franchisees and where they’re located. The franchisor might not provide full contact information for every current franchisee, but it should be willing to connect you with at least a few who can serve as references. It’s not a good sign if the company won’t provide this aid to due diligence.
Excessive Fees
You shouldn’t expect franchising to be cheap. In fact, it may be the largest investment you’ll ever make. When you read through the fees listed in the FDD, however, you should see a balance. The franchisor should not charge a high up-front fee and a high royalty and require you to pay a big markup on inventory. Excessive fees are a red flag that the franchisor is desperate for money, which points to a bad business system or financial mismanagement.
Tiny Territories
Look carefully at the territories outlined in your Franchise Disclosure Document. Unless you’re dealing with a ubiquitous fast-food franchise, the franchisor should not be seeding multiple locations per neighborhood. Tiny territories, like excessive fees, can be a sign that the franchisor is desperate for money. Do your research and know how much space you need to make your business profitable in a reasonable amount of time.
No Growth
Look at the FDD’s list of franchise openings and closures in the last three years. This will tell you the franchise’s rate of growth. Steady, upward growth is the easiest for a franchisor to manage and results in the most reliable returns for franchisees. Rapid growth in a short amount of time can be OK, but watch for signs of overgrowth or a coming correction. If the company hasn’t grown at all in the last three years, walk away. That’s a sign of a revolving-door franchisor (see “High Turnover,” above) or a saturated market.
Minimal Support
In my opinion, franchising has three primary advantages: the business system, the network, and franchisor support. The FDD must outline the technology, training, marketing and other support the franchisor will provide you. If this section of the document seems especially skimpy, that’s a red flag. You don’t want to pay tens or hundreds of thousands of dollars for a relationship that is missing a key component.
Need help making a smart decision about your franchise future? I walk through due diligence with all my candidates and am available for free coaching, even after they launch their businesses. Schedule a 20-minute call with me to learn more about how I can help you achieve your franchise dreams–my services are always free!
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