10 Tips for Performing Franchise Due Diligence

Like any good relationship, the one between franchisee and franchisor should be based on mutual trust. But that doesn’t mean potential franchisees shouldn’t do their homework before signing on the dotted line.

Due diligence is a critical component of any franchise purchase, and it should include a thorough quantitative and qualitative investigation of the entire franchise system. Below are 10 tips on how to make the most informed decision possible about your next franchise investment.

Read the FDD—like, actually READ the FDD. Reviewing the Franchise Disclosure Document—in depth, multiple times—is the easiest way to help protect your best interests. But, this simple step is often the one most ignored by potential franchisees, according to franchise consultant Steve Beagleman of SMB Franchise Advisors*.

“It is mind-blowing that someone would make such a large financial commitment without closely reviewing the documents outlining their purchase, but it happens all the time,” said Beagleman. “Review the Item 19 particularly closely. That section provides critical details on earnings, costs, and other factors that could affect your future financial performance and your earnings potential.”

If financial performance representations are provided, potential franchisees should review them carefully, along with the documentation behind them. If franchisors do not disclose financial performance in their Item 19, then potential franchisees should ask for the information instead.

Itemize the FDD. Potential franchisees can learn a wealth of additional information from the FDD, far beyond projections on earnings potential. Of particular note is Item 3 in the FDD, says Kay Ainsley, a franchise consultant with Michael Seid and Associates.

“Item 3 concerns litigation,” she said. “Don’t be scared off by (the fact that) some litigation appears there. It could mean that the franchisor is enforcing their brand standards. But, look for excessive litigation, where the franchisee is suing for fraud during the sales process or if many franchisees have filed suit for a (lack of) support. Also, look for any class action suits in which a large number of franchisees are banning together to sue.”

Other Items Ainsley also advises clients to pay close attention to inside the FDD include the following:

Review past disclosure compliance. This is where reading over multiple years of disclosure documents can become advantageous. Potential franchisees should track significant changes from year to year, along with things like how fast the franchisor is growing and the rate of turnover among franchisees. A high turnover rate could indicate a potential problem with the franchise system that a potential franchisees should be aware of.

Assess Your Liability. Vicarious liability is liability taken on by a franchisor due to the acts of a franchisee. Potential franchisees should always review the circumstances and frequency of claims against franchisors based on such claims. Strong franchise agreements often also require franchisees to carry liability insurance that names the franchisor as an additional insured. Franchisees should always verify compliance with these requirements from the franchisor before finalizing a purchase agreement.

Pick up the phone. Speaking with current franchisees in the system can yield a wealth of important information. And, don’t just stick to the short list of names provided by the corporate team, Beagleman recommended.

“Go through the Franchise Disclosure Document and start down the list,” he said. “And, don’t go into the calls cold. Have at least five or six good questions prepared. Ask the franchisees things like whether the business has met their financial expectations, and how long did it take them to get a return on their investment? Franchisees are usually pretty honest on those calls, because they were once in the same position you are.”

Ask the franchisor. It’s just as important to have a frank conversation with those selling the business as those who have bought it, Ainsley stressed.

“Ask things like: what are their plans for the future, for growing the concept and growing the brand? What traits, knowledge base and skills do their highest performing franchisees have? What are the market demographics of their highest performing units? And, why did they decide to franchise? The answer to that could be very telling about what the future of the business may be,” Ainsley said.

Assess compatibility. You don’t have to love the corporate team behind the concept you’re interested in. But, it could make for a rocky road ahead if you can’t find at least some common ground.

“Make sure you like the people,” said Beagleman. “Franchising is like a marriage: if you’re a bad match from the start, it probably won’t get better with time.”

Analyze growth possibilities. The question can be as simple as, “How much can I make?” But it has to be asked in the right way. Ask existing franchisees how they deal with their competitors, how long it took for them to break even and how they did their due diligence before jumping right to the money question. Ask too early in the conversation, or without tact or the wrong tone, and you risk upsetting the franchisee—and losing your shot at valuable insight into the brand.

Have a plan. Your plan for a franchise purchase should include preparations for contingencies you might not foresee. What if your desired territory isn’t available? What if you have difficulty obtaining the right financing? Ask franchisors what help might be available to you and where mutually beneficial compromises might be found.

Ask the experts. “Once you’ve determined this is the franchise opportunity you want and you’ve prepared a solid business plan, it’s important to have the FDD, franchise agreement and any other important documents reviewed by a franchise attorney,” said Ainsley. “It’s also important to have your business plan reviewed by an accountant, especially if you have any doubts about how it’s been put together or the numbers in it.”

“And, make sure that the attorney reviewing the documents is a franchise attorney,” Beagleman added. “A franchise attorney understands both your rights and your responsibilities and understands the risks and rewards that can come with buying a franchise. If you take the right steps, all of this can help protect you and set you on the right path to success.”