Three Steps to Evaluating a Franchise

The one question I hear asked the most often about franchising is, “How do I know if this is the right franchised business for me?” If I were asked that question by one of my three brothers, here’s how I would go about helping him evaluate the offering.

Step One: Consultation. I would explain that so much depends on what he likes to do with his time — on what he would both enjoy and be good at. There is so much more to choosing a franchise than finding an opportunity that will make money (although that is an important part of the evaluation). Equally important is evaluating your own skills and interests.

Step Two: Read the Franchise Disclosure Document. So many people don’t even look at this important document. What I have seen happen is that after reading several FDDs, people tend to think that they are all alike (well, they do look alike). My brother and I would go through it together. Here are the essential parts of the FDD I would insist we review (in the order I would look at them):

Items 3 and 4: A quick review of the litigation and bankruptcy disclosures. There may well be information here that would knock a franchise out of contention. If the president of the franchisor has been in federal prison for securities violations, or the franchisor has just emerged from Chapter 11 bankruptcy, we may not want to read any further.

Exhibit: Franchisor Financial Statements. I am not an accountant, but I would next look through the company’s financial statements, reviewing its assets, debts, and last year’s revenues. Does the company look healthy? What about the Quick Ratio (Current Assets divided by Current Liabilities)? Is it 2:1 or at least 1:1?

Exhibit: State-Specific Information. I would be looking for one important piece of information here: Has my state required this franchisor to make some arrangement, such as a surety bond, an escrow account, or a deferral of the initial fees, to protect investors in the state? Franchise registration states will require these arrangements if they conclude that the franchisor is not adequately capitalized or otherwise poses an unreasonable risk to investors. I would consider this an important signal about the investment, and if there are special arrangements made for investors, I would want my brother to be fully aware of it.

Item 13: Check to make sure the trademark is federally registered. I might even confirm the status of the registration myself at www.uspto.gov using the Trademark Electronic Search System (“TESS”).

Item 7: What is the estimated total investment? This item usually breaks it down to a range of total investment, taking into account a dozen variables. I’d talk with my brother about the resources he brings to the investment. The last thing I would want is for my brother to go into this, or any, business undercapitalized.

Cover Page: There are a couple key points in the Cover Pages, including summaries of the Item 7 estimates and the Item 5 initial fees, but I am interested in where the FDD is registered. Usually those states will be listed immediately following the State Cover Page. If no franchise registration states were listed as currently registered, I would make a note to ask the company about it. As my brother lives in Maryland, a registration state, I would call the Attorney General’s Office in Baltimore to confirm that the franchisor is currently registered in Maryland.

Item 20: Statistics and Lists. I would want to learn how many franchises are in the system, and in which states they are located. Then I would take a look at the list of franchisees in the exhibits and look at the names and locations of franchisees in our state. This will tell us a bit about where my brother would fit into the system. Is his market crowded, or would he be the first to locate in his part of the state? I would insist that my brother call a number of the franchisees listed and ask them about their experience with this business.

Read the Balance of the FDD. My brother and I will have to read the rest of the FDD so that we could discuss anything that we did not understand or that seemed confusing.

Step Three: Bring in the pros. (See article Buying a Franchise? Get the Right Professional Help.) My brother will need a professional accountant to help him prepare a business plan, determine when he might hit a break-even point, consider whether the business has a good chance of being profitable, and structure the financing he will need. I think I would also bring in another attorney to handle any negotiations with the franchisor. I’m not sure I could be a dispassionate advocate for his interests.

Even with that level of study, there are no guarantees, of course. But if I help my brother locate key information and talk about how to evaluate it as he makes his decision, I will have done my best to help him make the right choice.