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Before You Sign an Agreement: What Should Scare You as a Franchisee

From previous litigation to financial performance representations, candidates need to dive into the due diligence process to ensure they have all the information before committing to a franchise concept.

Franchising offers entrepreneurs a business opportunity that is backed by a proven system that can (ideally) catapult them toward success and profitability. But not all franchise concepts are created equal, and before prospects sign their life savings away, it’s important to do their research on a brand to ensure it’s the real deal. There are several red flags that should give franchisee prospects pause or scare them away completely when reading an FDD or franchise agreement

“One of the first places I want franchisees to look at is the Item 20 of the FDD — how many units have opened, how many closed,” said Franchise Captain founder Corey Elias. “If a brand is closing more units than they are opening, that could be a problem. Sometimes it can be explained, but franchisees want to join a system that people are already successful in.”

Litigation — or Item 3 — is another potential red flag, Elias says. “If brands have litigation on the books, it can be a bad sign,” he said. “But it is also a matter of understanding why that litigation exists. If a brand is large, with hundreds of units, they will likely end up with at least some litigation. It takes time and research to really dig in and understand if those instances are red flags or not.”

Charlie Bever, a senior franchise consultant with The Entrepreneur Authority, says too many fees can also scare prospective franchisees away from a concept. “Someone who is new to exploring franchises may be turned off by the fees,” he said. “The fees the franchisor charges the franchisee should equal or exceed the value that they can bring the franchise owner. If the value isn't apparent, this could turn prospects away.”

Additional red flags which need to be heavily considered are any bankruptcies, too many owners exiting the system and a lack of projected growth by state for the franchisor, Bever says. 

“Also, a weak financial performance or lack of a thorough financial performance representation (Item 19) could be a deterrent,” said Bever. “If the data surrounding the items mentioned is negative, this may require deeper questioning of the franchisor.”

To dig deeper into all of these factors, Elias says validation — talking to existing franchisees — is essential. “These are people who followed the model and have hopefully seen success, so talking to existing franchisees like that gives prospects a real-life example of what to expect,” said Elias. “Franchisees are also relatively unbiased — there is no financial incentive to lie. They will tell you how it is: the good, the bad and the ugly.”

If franchisees find an alarming number of complaints about the franchise from other franchisees, it may be a sign to avoid moving forward with the process. But Elias says it is important to take franchisee complaints with a grain of salt.

“The process of choosing a franchise is extremely personal — is the concept right for me? If I talk to five franchisees and only one gives me a bad review, I’m not overly worried unless that person has a very similar situation and background,” said Elias. “If they are struggling because they don’t have a sales background, and I also don’t have a sales background, that could be a problem. Dig deeper — talk to other franchisees, focus on that sales background and figure out if it is really a problem.”

Bever says he instructs all of his candidates to make at least five validation calls during the due diligence process. “That way you have a nice cross-section of opinions,” he said. “If you made five calls and all were negative this would be an obvious problem. It usually doesn't happen like that though. For every ‘bad’ call, the prospect likely receives four positive calls or reviews. Making validation calls is a crucial part of the investigative process.”

By keeping all of these potential hazards in mind, candidates can be better prepared to analyze several franchise opportunities and discern which ones are well-positioned for success. Prospects should also enlist the help of professional franchise brokers and consultants, who can help them ask the right questions and get to the bottom of potential red flags.