Before you take the steps to invest in any franchise system, be sure to get a copy of the franchisor's
disclosure document. Sometimes this document is called a Franchise Offering Circular.
Under the FTC's Franchise Rule, you must receive the document at least 10 business days
before you are asked to sign any contract or pay any money to the franchisor. You should
read the entire disclosure document. Make sure you understand all of the provisions. The
following outline will help you to understand key provisions of typical disclosure
documents. It also will help you ask questions about the disclosures. Get a clarification
or answer to your concerns before you invest.
- Business Background
- The disclosure document identifies the executives of the franchise system and describes
their prior experience. Consider not only their general business background, but their
experience in managing a franchise system. Also consider how long they have been with the
company. Investing with an inexperienced franchisor may be riskier than investing with an
experienced one.
- Litigation History
- The disclosure document helps you assess the background of the franchisor and its
executives by requiring the disclosure of prior litigation. The disclosure document tells
you if the franchisor, or any of its executive officers, has been convicted of felonies
involving, for example, fraud, any violation of franchise law or unfair or deceptive
practices law, or are subject to any state or federal injunctions involving similar
misconduct. It also will tell you if the franchisor, or any of its executives, has been
held liable or settled a civil action involving the franchise relationship. A number of
claims against the franchisor may indicate that it has not performed according to its
agreements, or, at the very least, that franchisees have been dissatisfied with the
franchisor's performance. Be aware that some franchisors may try to conceal an executive's
litigation history by removing the individual's name from their disclosure documents.
- Bankruptcy
- The disclosure document tells you if the franchisor or any of its executives have
recently been involved in a bankruptcy. This will help you to assess the franchisor's
financial stability and general business acumen and predict if the company is financially
capable of delivering promised support services.
- Costs
- The disclosure document tells you the costs involved to start one of the company's
franchises. It will describe any initial deposit or franchise fee, which may be
non-refundable, and costs for initial inventory, signs, equipment, leases, or rentals. Be
aware that there may be other undisclosed costs. The following checklist will help you ask
about potential costs to you as a franchisee.
- Continuing royalty payments.
- Advertising payments, both to local and national advertising funds.
- Grand opening or other initial business promotions.
- Business or operating licenses.
- Product or service supply costs.
- Real estate and leasehold improvements.
- Discretionary equipment such as a computer system or business alarm system.
- Training.
- Legal fees.
- Financial and accounting advice.
- Insurance.
- Compliance with local ordinances, such as zoning, waste removal, and fire and other
safety codes.
- Health insurance.
- Employee salaries and benefits.
It may take several months or longer to get your business started. Consider in your
total cost estimate operating expenses for the first year and personal living expenses for
up to two years. Compare your estimates with what other franchisees have paid and with
competing franchise systems. Perhaps you can get a better deal with another franchisor. An
accountant can help you to evaluate this information.
- Restrictions
- Your franchisor may restrict how you operate your outlet. The disclosure document tells
you if the franchisor limits:
- The supplier of goods from whom you may purchase.
- The goods or services you may offer for sale.
- The customers to whom you can offer goods or services.
- The territory in which you can sell goods or services.
Understand that restrictions such as these may significantly limit your ability to
exercise your own business judgment in operating your outlet.
- Terminations
- The disclosure document tells you the conditions under which the franchisor may
terminate your franchise and your obligations to the franchisor after termination. It also
tells you the conditions under which you can renew, sell, or assign your franchise to
other parties.
- Training and Other Assistance
- The disclosure document will explain the franchisor's training and assistance program.
Make sure you understand the level of training offered. The following checklist will help
you ask the right questions.
- How many employees are eligible for training?
- Can new employees receive training and, if so, is there any additional cost?
- How long are the training sessions?
- How much time is spent on technical training, business management training, and
marketing?
- Who teaches the training courses and what are their qualifications?
- What type of ongoing training does the company offer and at what cost?
- Whom can you speak to if problems arise?
- How many support personnel are assigned to your area?
- How many franchisees will the support personnel service?
- Will someone be available to come to your franchised outlet to provide more individual
assistance?
The level of training you need depends on your own business experience and knowledge of
the franchisor's goods and services. Keep in mind that a primary reason for investing in
the franchise, as opposed to starting your own business, is training and assistance. If
you have doubts that the training might be insufficient to handle day-to-day business
operations, consider another franchise opportunity more suited to your background.
- Advertising
- You often must contribute a percentage of your income to an advertising fund even if you
disagree with how these funds are used. The disclosure document provides information on
advertising costs. The following checklist will help you assess whether the franchisor's
advertising will benefit you.
- How much of the advertising fund is spent on administrative costs?
- Are there other expenses paid from the advertising fund?
- Do franchisees have any control over how the advertising dollars are spent?
- What advertising promotions has the company already engaged in?
- What advertising developments are expected in the near future?
- How much of the fund is spent on national advertising?
- How much of the fund is spent on advertising in your area?
- How much of the fund is spent on selling more franchises?
- Do all franchisees contribute equally to the advertising fund?
- Do you need the franchisor's consent to conduct your own advertising?
- Are there rebates or advertising contribution discounts if you conduct your own
advertising?
- Does the franchisor receive any commissions or rebates when it places advertisements? Do
franchisees benefit from such commissions or rebates, or does the franchisor profit from
them?
- Current and Former Franchisees
- The disclosure document provides important information about current and former
franchisees. Determine how many franchises are currently operating. A large number of
franchisees in your area may mean increased competition. Pay attention to the number of
terminated franchisees. A large number of terminated, cancelled, or non-renewed franchises
may indicate problems. Be aware that some companies may try to conceal the number of
failed franchisees by repurchasing failed outlets and then listing them as company-owned
outlets.
If you buy an existing outlet, ask the franchisor how many owners operated
that outlet and over what period of time. A number of different owners over a short period
of time may indicate that the location is not a profitable one, or that the franchisor has
not supported that outlet with promised services.
The disclosure document gives you the names and addresses of current franchisees and
franchisees who have left the system within the last year. Speaking with current and
former franchisees is probably the most reliable way to verify the franchisor's claims.
Visit or phone as many of the current and former franchisees as possible. Ask them about
their experiences. See for yourself the volume and type of business being done.
The following checklist will help you ask current and former franchisees such questions
as:
- How long has the franchisee operated the franchise?
- Where is the franchise located?
- What was their total investment?
- Were there any hidden or unexpected costs?
- How long did it take them to cover operating costs and earn a reasonable income?
- Are they satisfied with the cost, delivery, and quality of the goods or services sold?
- What were their backgrounds prior to becoming a franchisee?
- Was the franchisor's training adequate?
- What ongoing assistance does the franchisor provide?
- Are they satisfied with the franchisor's advertising program?
- Does the franchisor fullfill its contractual obligations?
- Would the franchisee invest in another outlet?
- Would the franchisee recommend the investment to someone with your goals, income
requirements, and background?
Be aware that some franchisors may give you a separate reference list of selected
franchisees to contact. Be careful. Those on the list may be individuals who are paid by
the franchisor to give a good opinion of the company.
- Earnings Potential
- You may want to know how much money you can make if you invest in a particular franchise
system. Be careful. Earnings projections can be misleading. Insist upon written
substantiation for any earnings projections or suggestions about your potential income or
sales.
Franchisors are not required to make earnings claims, but if they do, the FTC's
Franchise Rule requires franchisors to have a reasonable basis for these claims and to
provide you with a document that substantiates them. This substantiation includes the
bases and assumptions upon which these claims are made. Make sure you get and review the
earnings claims document. Consider the following in reviewing any earnings claims.
- Sample Size. A franchisor may claim that franchisees in its system earned, for
example, $50,000 last year. This claim may be deceptive, however, if only a few
franchisees earned that income and it does not represent the typical earnings of
franchisees. Ask how many franchisees were included in the number.
- Average Incomes. A franchisor may claim that the franchisees in its system earn
an average income of, for example, $75,000 a year. Average figures like this tell you very
little about how each individual franchisee performs. Remember, a few, very successful
franchisees can inflate the average. An average figure may make the overall franchise
system look more successful than it actually is.
- Gross Sales. Some franchisors provide figures for the gross sales revenues of
their franchisees. These figures, however, do not tell you anything about the franchisees'
actual costs or profits. An outlet with a high gross sales revenue on paper actually may
be losing money because of high overhead, rent, and other expenses.
- Net Profits. Franchisors often do not have data on net profits of their
franchisees. If you do receive net profit statements, ask whether they provide information
about company-owned outlets. Company-owned outlets might have lower costs because they can
buy equipment, inventory, and other items in larger quantities, or may own, rather than
lease their property.
- Geographic Relevance. Earnings may vary in different parts of the country. An
ice cream store franchise in a southern state, such as Florida, may expect to earn more
income than a similar franchise in a northern state, such as Minnesota. If you hear that a
franchisee earned a particular income, ask where that franchisee is located.
- Franchisee's Background. Keep in mind that franchisees have varying levels of
skills and educational backgrounds. Franchisees with advanced technical or business
backgrounds can succeed in instances where more typical franchisees cannot. The success of
some franchisees is no guarantee that you will be equally successful.
- Financial History
- The disclosure document provides you with important information about the company's
financial status, including audited financial statements. Be aware that investing in a
financially unstable franchisor is a significant risk; the company may go out of business
or into bankruptcy after you have invested your money.
Hire a lawyer or an accountant to
review the franchisor's financial statements. Do not attempt to extract this important
information from the disclosure document unless you have considerable background in these
matters. Your lawyer or accountant can help you understand the following.
- Does the franchisor have steady growth?
- Does the franchisor have a growth plan?
- Does the franchisor make most of its income from the sale of franchises or from
continuing royalties?
- Does the franchisor devote sufficient funds to support its franchise system?
Before you invest in a franchise system, investigate the franchisor thoroughly. In
addition to reading the company's disclosure document and speaking with current and former
franchisees, you should speak with the following:
