Approach Franchise Affiliation With Eyes Wide Open

August 1, 2004

You’ve met with sales representatives of a franchise to determine whether affiliation with the system might benefit your company. But it’s a big step. Taking it requires you to make a major upfront financial investment—in franchise fees, new signage, maybe even a different color on your office walls—and it commits you to payments going forward, including monthly royalties and contributions to an advertising fund.

Then there are the low-probability but high-impact events to consider. What if the franchisor becomes embroiled in a high-cost, high-profile lawsuit? Even if the matter doesn’t directly involve you, you’re affected. For good or ill, your company’s brand identity is now linked in the minds of consumers and your business partners to that of the franchisor.

Given the high stakes of affiliation, you must enter into a franchise agreement with your eyes wide open, something federal and state regulators want to make as easy as possible. The Federal Trade Commission and some states require franchisors to provide you a wide array of information upfront—an accounting of pending and closed lawsuits against the company, for example, and details about your initial investment and ongoing fees—to help you make an informed decision about purchasing a franchise. Franchisors are also required to provide the information in a standardized format, in a document known as the uniform franchise offering circular or UFOC.

But knowing a franchise brand intimately is easier said then done. The UFOC is an imposing document that, with attachments, can run hundreds of pages. What’s more, some of the key operational information you need to conduct your due diligence—what are the franchisor’s rules on record keeping, what are its policies on signage?—might be hidden away in the company policy manual rather than in the UFOC. Since companies can change the policies in their manual at any time, these changes can impact your bottom line if they result in unforeseen costs to you.

What’s more, companies aren’t obligated to show you their policy manual because it’s an internal document. Some will let you look at it but not take it with you, making a thorough review difficult.

So, how do you cover your bases before entering into a franchise agreement? First, know the principal question you need to answer:

Does the value I receive from affiliating with the franchisor’s brand identity, advertising muscle, training program, and business process offset the economic investment I’ll make and the operational control I’ll give up?

Second, do your due diligence. You can’t answer that question without first digging into the UFOC. All UFOCs include a table of contents to help you review the document by section.

10 due diligence steps

Review the UFOC with an eye toward the issues affecting your financial investment and the amount of control you’ll relinquish. Among the issues to consider:

1. Entry and exit costs.

How much will it cost to convert your office? The UFOC requires disclosure of these costs, but franchisors typically provide a broad range—in real estate, a spread as wide as $21,000 to $250,000—making it hard for you to know what your costs will be.

The reason for the range: Your costs are unique. At the very least, you’ll need to change your signs and letterhead and pay the initial franchise fee, among other things. But you may also need to add or upgrade equipment or hire additional staff.

Then there are exit costs. How much will you incur in “de-identification” and other conversion costs to leave the system? Exit costs aren’t included in the UFOC, so you have to estimate them yourself.

2. Ongoing value.

You face monthly royalty payments; other regular fees, such as for referrals (independent companies can choose whether to belong to a third-party referral group—in a franchise, belonging to the referral group is part of the affiliation); and indirect costs. If the franchisor imposes mandatory training on you, for example, you might have to absorb your travel costs if the training is off-site.

For all these ongoing costs, what value will you receive? Are the referrals worth the fees? Is the training worth the cost? Will the franchisor’s affiliated businesses—perhaps it owns a financial services company—drive customers to you that you otherwise wouldn’t get? Conduct a cost-benefit analysis, examining your additional monthly costs against the additional income you expect to receive to get a picture of the value of joining the brand.

3. Earnings claims.

Franchisors aren’t required to disclose how much they think you’ll earn; nor are they required to give you historical data on their franchisees’ earnings. If the franchisor doesn’t report its franchisees’ earnings in the UFOC—and most don’t—ask why it doesn’t. After all, the franchisor requires its franchisees to report their earnings, so it has the data available.

4. System growth.

Is the number of franchisees growing or contracting? Is the number of company-owned operations increasing or declining? This may be the most important information you review. A declining or stagnating number of franchisees (and a growing number of company-owned offices) may suggest that the system isn’t healthy. A high number of terminations or non-renewals may also be troubling.

The UFOC requires franchisors to disclose this data for the three most recent years, but it can be hard for prospective franchisees to identify turnover rates in the system because the numbers are disclosed in aggregate for the entire franchise network. If, in a given year, a franchisor loses one franchisee in an area but gains a replacement franchisee, for example, the data would show no change for that year, suggesting a stable picture. But is the system really stable? For your purposes, it might be more important to know why that one franchisee left.

5. Franchisee input.

The most valuable research you can do is to talk with existing and past franchisees, whose contact info the UFOC requires franchisors to disclose. The best question to ask them: If you had to do it all over again, would you do it?

In general, franchise agreements contain confidentiality provisions that restrict franchisees from talking about matters proprietary to the system, such as internal business processes. What you’re looking for, though, is a subjective assessment from the franchisee that the system’s value proposition is sound—that is, the benefits you get from affiliating exceed your costs to belong.

Seek input from past franchisees, too, but be aware that brokers who’ve left the system tend to be those most unhappy with it. So weigh what they say with that in mind. Also, if the franchisees have an association or if the franchisor maintains a franchise advisory council, talk to the leaders of those bodies. Very often, they’re among the most widely respected and long-standing franchisees in the system, and they bring historical knowledge that may surpass even that of some of the franchisor’s employees.

One important point: In real estate, unlike in many other industries, franchise agreements tend to come without post-expiration non-compete clauses. That’s good for franchisees because, if they opt not to renew their franchise agreement, they can convert identities and continue operations without skipping a beat. Franchise systems in many other industries don’t permit ex-franchisees that same freedom. Given this flexibility, you can expect real estate franchises to have higher turnover rates than franchises in other industries, all else being equal.

6. Litigation.

The UFOC requires the franchisor to disclose all its pending and resolved lawsuits for the last seven fiscal years. Compare its number of lawsuits (those it has initiated and those against it) with its number of franchisees. There’s no rule of thumb for what constitutes a high ratio of litigation. But it’s probably safe to say that a franchisor with 1,000 franchisees and three pending lawsuits isn’t overly litigious.

Also look at how the franchisor responds to lawsuits. Does it settle quickly or does it tend to go to the mat each time? A reading of the UFOC will show you how the franchisor approached each suit because the UFOC requires the franchisor to provide a narrative for each. How the company responds can tell you something about its character and culture.

Note what the lawsuits tend to be about. Is there a pattern? As a general matter, many lawsuits are initiated by franchisors against franchisees for non-payment of royalties and fees. But look below the surface. In some cases, franchisees don’t pay their fees because they feel they aren’t getting the value they were led to believe was there. The narrative describing each suit should provide the argument for any counter-charges by the franchisee. To supplement that information, talk to former franchisees.

7. Franchisor personnel.

Look at who the franchisor’s top executives are. That information, usually in the form of short biographies, is required to be in the UFOC. Pay particular attention to executives who’ve come from other industries. Some systems are historically more litigious than others. One sandwich chain, for example, is generally recognized as highly litigious. It’s helpful to know if an officer comes from such a system. If so, that officer might be quicker to resort to litigation to settle a matter than another officer. To learn about other franchises, contact a franchisee association, attorney, or accountant.

Other things to look for: 1) Nepotism. Are franchise operations managed by family members? If they are, the best people might not be in management positions. 2) Bankruptcies. Have any of the top executives been involved in bankruptcies in other systems? Contact franchisee associations, attorneys, or accountants to find out.

8. Exclusivity.

How much protection do you have from encroachment into your territory? Does any exclusivity you have extend to Web site marketing and relocation referrals? You know you’ll be competing with other brokerages, franchised and independent. But could the franchisor you’re considering joining be among your competitors as well?

9. Financials.

The UFOC mandates disclosure of franchisor financial statements for the previous three years. Show these to your accountant. One thing to look for: Where is the franchisor getting the bulk of its income? If it’s from initial franchise fees rather than royalties, that could signal turnover among franchisees. A more promising picture is a company whose lifeblood is royalty income. That signals income from ongoing operations.

10. Sloppiness.

For franchisors, complying with UFOC requirements can be costly. These pre-disclosure documents are complicated and extensive. Signs of sloppiness—miscalculations, misspellings, internal inconsistencies—should raise concerns that the franchisor isn’t devoting proper resources to a very important task, one with legal ramifications.

Besides typos, look for inconsistencies. For instance, a franchisor might disclose the number of franchisees in as many as three different parts of the UFOC. These numbers should be the same in each case. If they’re not, what does that say about how careful the company has been in preparing the UFOC and how much in the way of resources and competence it brings to its operations in general?

The title page of the UFOC pointedly recommends that prospective franchisees review the UFOC with an adviser, such as an attorney or accountant. But take time to conduct your own careful due diligence as well. Proceeding with your eyes wide open can make the difference in how much your company benefits from a franchise affiliation.

Karp, a partner in the law firm Witmer, Karp & Warner LLP in Boston, serves as counsel to several national franchisee associations and serves on the board of the American Franchisee Association. You can reach him at 617/423-7250 or ekarp@witmerkarpwarner.com.

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