10 Red Flags In Evaluating a Franchise

An enterprising individual looking to get into a business needs to evaluate multiple aspects prior to entering any commitment. This individual must ask of him/her self if it would be preferable, and in his/her best interest, to buy an existing business or to start a new business from scratch.

In researching an existing business, proper paperwork must be obtained and evaluated. This paperwork should include:

• The last year's profit and loss statement and balance sheet.
  
• Monthly profit and loss statements and balance sheets for the current year.
  
• Monthly sales volumes since the inception of the business.
  
• The last three years' tax returns.
  
• The lease agreement of the property.
  
• A clear understanding of what the seller is actually looking to sell and what you are looking to buy.

However, with a start-up business, investigating past performance is an impossible task, since none exists. Investigation must take a different track and is accomplished by looking at the potential and projections. To cover most aspects, the researcher absolutely should do a business plan, the format of which can be obtained via the Internet.

If the business one is contemplating buying, whether it is a start-up or existing business, is a franchise, many of the above rules may apply, but additional areas of concern must also be red-flagged and investigated.

The first red flag to consider is whether the owner is being selective in choosing its franchisees. If they would sell one to just about anyone regardless of qualifications, character, finance, and ability to successfully run this franchise, would you be sure that you, perhaps, are suited to this type of business?

The company should have a set of criteria for profiling and determining the suitability of each of its potential recruits, not just the singular function of determining if they can afford to purchase it.

Red flag No. 2: Is it a mature business? Most "new" franchise systems exhibit an extremely high degree of optimism. The salesperson enthusiastically intimates how great a business system he/she is selling and, through inference, how successful you can become. There is no track record to support these claims.

The length of time a company has been franchising, therefore, becomes an important criterion in your ability to evaluate that system. A newer one certainly presents a ground floor opportunity, with possible higher earning potentials, but certainly greater risk. A more mature one usually produces opposite results.

TURNOVER PROBLEMS

The stability of the organization is red flag No. 3. Franchisors, for multiple reasons, sometimes exhibit a very high turnover of franchises. The bottom line is, usually, the unit owner is not making the type of money he/she expected at that time period in his/her development.

Most companies will have some turnover of franchises. However, a high percentage of turnovers is a strong red flag that something is amiss with the business.

A number of outlets will include information on franchisees who have left the system. As many of those past unit owners as possible should be contacted for input during your evaluation of the business.

The fourth red flag has to do with the training offered. It is a partnership between two parties in which the franchisor is responsible for providing the experience and expertise to the recruit, who usually has no knowledge of this type of business.

Look for a franchisor that is selective in choosing its franchisees.

This expertise must be transmitted by a franchisor's initial training and subsequently by ongoing support. If the franchisor has a substandard training program and is lax in its on-going support to enable you to successfully run the business, then this would be a red flag indicating the franchise would not be fulfilling its responsibility.

Does the franchisor exhibit integrity? Falling short in this area is red flag No. 5. Lawsuits are prevalent.in today's society and one must be wary of overreacting to lawsuits. A franchisor that does not keep his word will normally have a greater percentage of lawsuits filed against him.

A prudent buyer should conduct due diligence for the number and types of complaints filed against the franchisor. Both the number and type of complaints could be a warning flag about the integrity of the company.

The satisfaction level of existing franchisees is the sixth red flag for which prospective franchisees must be on the lookout. Existing unit owners can be a good barometer of how the franchise system is working.

Current unit owners are in a position to advise other new recruits of some of the pitfalls and negative attributes of the franchisor. Just as importantly, some recruits may speak very favourably of the opportunity. The true mix most often lies somewhere between the two extremes. The new franchisee should be prepared to balance between these different, varied opinions. 

OWNERSHIP CONSIDERATIONS

Red flag No. 7: Does the franchisor have any company-owned units and, if so, how many?

Competition in business is extremely healthy. Evaluate the existing competition. Your chances of success will be dependent on your ability to gain market share by providing a service or product at a better price or with better service or with greater convenience than your competitors.

You should not be scared of competition, but you should realize that competition is the foundation of our free economic system. Very often it-has a synergistic effect. For example, garment districts are made up of many tradesmen, main street USA has a multitude of fast-food outlets next to each other, and in any major shopping centre there is usually more than one anchor store selling the same merchandise.

However, you should not expect undue competition from your own franchise company. The expertise that the franchisor has provided you through training should not be used to compete against you. If the franchisor has only a handful of company-owned stores that are used for training and R&D, that is a positive sign.

Red flag No. 8: What is the budget available for expanding the franchise system?

A franchise is built upon two components. One is the business itself that is directly related to the recruit’s ability. The other is the owner’s ability to expand its system and create a demand for people to buy into it.

When a red flag pops up, it signals a need for deeper investigation.

The amount of money available in the owners budget is going to directly reflect on the ability to expand the system. Therefore, a cash poor franchise will limit the franchisee's ability to succeed in this second area.

The ninth red flag has to do with the franchisor's registration status. Is it registered to do business in states with that requirement?

Every franchise sold in the United States must comply with Federal Trade Commission requirements. However, many states also have their own extra requirements. While a franchisor's decision not to do business in registration states is not necessarily a negative indicator, its reasons for making that choice should be examined.

The final red flag you must be on the lookout for is the situation where the franchisor is also your landlord. Many franchise agreements require that the franchisor lease your space and then sublease it back to you. This is a definite red flag.

So there they are, the 10 red flags of franchising.