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10 Tips for Performing Franchise Due Diligence

Once you’ve found a franchise opportunity that you are interested in, it’s time to do your homework.

For many, purchasing a franchise will be the most significant investment they’ll ever make, and no one should ever buy a franchise without performing the proper due diligence. Whether it be looking over the Franchise Disclosure Document or talking to advisors, it’s imperative to really dig in and do the research required to get a full understanding of the brand and the franchise requirements.

Here are 10 tips for performing franchise brand due diligence before signing on the dotted line.

Really Read the Franchise Agreement

While this may sound basic, many people don’t fully read and understand the franchise agreement in its entirety. Oftentimes, people pass it over to an advisor to look over, but if you want to buy into the franchise you need to understand the full obligations. Potential franchisees shouldn’t be afraid to ask questions about the agreement. Make sure you understand what you’re getting into as a franchisee.

Seek Franchisee Validation

It’s important to speak to a whole bevy of individuals when doing your homework. Franchises might have a list of recommended franchisees to speak to, but break out of the habit of only contacting these individuals. Moreover, consider speaking to those who have left the system to get their perspective and experience with the brand. A good rule of thumb is to call 10 to 15 franchisees.

Seek the Advice of Experts  

When contemplating buying into a franchise system, don’t go to any old attorney. Make sure to seek out a franchise business advisor or a franchise attorney for help. Franchise professionals are experts in the industry and know the ins and outs of franchise agreements. Don’t risk wasting time or money with someone who doesn’t understand the franchise requirements. Allowing an industry professional to review your documentation and research will afford a much-needed perspective and will hopefully yield some insight. Encourage experts to play devil’s advocate and help you examine the franchise from every objective vantage point.

Understand the Unit-Level Economics 

This would be in Item 19 of the Franchise Disclosure Document. It’s important to review and understand the unit economics of the franchise. Make sure to review the full Profits and Losses Statement. If the P&L is not provided in Item 19, make sure to get it from one of the franchisees you speak to.

Find the Actual Costs of Initial Investments

Item 7 of the FDD lists the startup costs of a franchise, but it’s only limited to the first three months of working capital. If it takes longer to break even, startup costs could be much higher. Make sure to really dig into the costs that will be associated with joining the brand.

Learn Your Liability 

Many franchisees do not realize that they are subject to what’s called “vicarious liability,” which is taken on by a franchisor due to the acts of a franchisee. Reviewing the circumstances and frequency against your franchisor will provide you with a crucial impression of what’s to come in this business relationship. Assessing your personal financial liability and resources is also an integral part of the due diligence process. 

Analyze Growth Possibilities 

It’s important to see data relating to franchise growth, and Item 20 is where you will find it. Item 20 is a growth chart of the brand over the last three years. If a brand is not growing, it should be a concern. Make sure to get to the bottom of it, so you can make an informed decision, and discuss your growth plan with established franchisees to gauge the scalability of the business.

Talk to the Leadership Team

If possible, get to understand what the leadership team’s vision of the company and business philosophy. Whether it is during a discovery day or separate phone call, try to find out where the brand and industry are going and how they plan on staying relevant. This will give you a sense of what direction the organization is heading in and whether you have confidence in the leadership of the organization.

Dig Into the Company’s Audited Financial Statements

You want to look for a brand that has the capital to continue supporting the franchise system. Reading the footnotes of the audited financial statement is where you will get insight on how the numbers are derived from the audit.

Look at the Lawsuits

Understand and ask questions if there is any litigation listed in Item 3 of the FDD. Lawsuits aren’t necessarily a red flag — the longer a franchise has been around and the larger it is, the more likely it is that legal issues have arisen. Make sure to ask questions and understand what stemmed from the litigation. Always keep an eye out for any concerning signs.