Steps to Take Before Buying a Franchise
Buying a franchise is often a life-changing event, and it is important to understand your risks and obligations before finalizing the deal. To help protect your interests while making your investment decision, read on for steps that you can take and questions you may want to consider when evaluating a possible franchise purchase.
What is a franchise?
The Federal Trade Commission (FTC) typically governs franchise relationships through regulations commonly referred to as the Franchise Rule. To be subject to the Franchise Rule, the business arrangement must include each of the following three features: (1) your right to use a commercial symbol of the franchisor, such as a trademark or logo; (2) the franchisor’s commitment to retain significant control over the operation of your business or to provide significant assistance to your business operations; and (3) your payment to the franchisor of at least $615 either before or during the initial six months of operation of your business (the FTC may adjust this amount for inflation every four years). The remainder of this article focuses on franchises subject to the Franchise Rule.
What information should I review before purchasing a franchise?
One of the most critical steps you can take before purchasing a franchise is to review the Franchise Disclosure Document (the FDD), a document that provides various disclosures in 23 categories (each called an Item in the FDD) to help you determine whether to buy the franchise. An FDD must be provided to you by a franchisor before you make any payment to the franchisor or sign a contract with the franchisor.
In addition to the fee disclosures and financial performance representations, which are discussed in more detail below, key Items in the FDD include:
The prior business experience as well as the litigation and bankruptcy history of the franchisor.
The officers, managers, directors, and other key employees of the franchise.
Whether your territory would be exclusive and any limitations to your territorial rights.
A description of any initial and ongoing assistance provided to you, including a summary of training.
The financial statements of the franchisor, which must be audited by an independent certified public accountant.
A list of the existing franchised and company-owned units in the franchisor's national system and information regarding the recent history of those locations.
Beyond evaluating the FDD, you should review and, as applicable, negotiate the proposed franchise agreement. This agreement will control your relationship throughout its term, so it is important to include favorable terms to the greatest extent possible. Be sure the agreement contains any provisions you deem critical and propose any desired modifications to the agreement before you sign it, because this is when you will likely have the most leverage to negotiate with the franchisor.
Areas warranting extra attention in the franchise agreement include:
Whether you will be granted an exclusive territory as well as any ability to expand your territory and any exceptions to it.
The extent of any operating obligations and procedures, such as whether you will be required to maintain a certain amount of inventory or working capital.
Any included non-compete clauses that would prevent you from operating a similar business during or after your franchise ends.
The amount and method for calculating any royalties and other fees that must be paid to the franchisor.
Any costs and restrictions if you want to transfer or renew your franchise.
The details around the franchisor’s ability to purchase your franchise at the end of the agreement.
Any incidents or occurrences that would allow the franchisor to terminate your franchise agreement.
Be prepared to walk away if the franchisor expects you to sign an unacceptable franchise agreement. It is typically less costly to end negotiations of a contract than it is to terminate one after execution.
How much will it cost me to purchase and own a franchise?
It is crucial for you to understand the fees you will incur in purchasing and operating a franchise. The FDD fee disclosures specify:
The initial fees you must pay to or on behalf of the franchisor before your business opens.
An estimate of the initial investment that is required for you to build, open, and begin operating your franchise (be sure fees such as construction costs are not underestimated for your location).
Other fees you must pay during the life of your franchise, such as: (a) customer relationship management fees (to administer a customer service program); (b) royalty fees (which may be based on your gross revenue, a flat fee, or a combination of these methods); (c) service fees (such as brand building fees); (d) successor or transfer fees (that compensate the franchisor upon the extension or transfer of the franchise agreement); (e) technology fees; and (f) expense reimbursement and cost recovery fees, such as interest and late fees and attorneys’ fees if there are legal disputes.
If the franchisor provides financial performance representations (projections or claims regarding your potential earnings), the franchisor must include the material assumptions or bases for the projection or claim. If not otherwise provided, consider requesting a geographical breakdown for any financial performance representations.
What else should I consider or do before buying a franchise?
Reach out to several existing franchisees to get their perspective on the investment. For example, consider asking them about pros and cons, hidden costs, lessons learned, historical performance information, steps taken for success, and whether they would recommend the franchise to a friend or family member.
Assess whether the franchisor’s existing systems, support, and coaching will help the success of your franchise. Understand the franchisor’s values, vision, and culture to ensure they align with yours. Determine what aspects of the franchise you will be able to tailor and whether this level of autonomy is acceptable to you.
Consider retaining professionals, such as an attorney and an accountant, to help complete your due diligence in reviewing the FDD, franchise agreement, financials, and other franchise information. Often the FDD itself is hundreds of pages long and having experienced specialists on your side can give you peace of mind by expanding your understanding of the information, as well as alerting you to any areas of concern and providing methods to address or minimize any concerns.
Finally, as with any other significant investment, carefully consider the opportunity and do not rush your assessment, because a hasty decision could have a significantly negative impact on your life. Alternatively, conducting a thorough evaluation of your options before you commit will significantly improve the likelihood that your new business will help you thrive.
This update is for informational purposes only and does not provide legal advice. Every legal situation is different and must be independently analyzed by an attorney. Please consult with an attorney for specific guidance.
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