Franchisee Financial Due Diligence

by David Cahn and Jeremy Robinson
Opportunity World
Published July 2008

One of the more perplexing questions facing franchisees when deciding to purchase franchise rights is whether their franchise unit will generate a profit and constitute a wise investment. Franchise unit performance data is a critical tool in evaluating franchise systems. The complexity of this data may range from simple gross sales averages taken straight from monthly royalty reports to complicated pro formas breaking down statistics by months of operation, location, etc.

There are several methods whereby potential franchisees may find out about a franchise unit’s financial performance. A franchisor may choose to provide this information to prospective franchisees as part of their recruitment system, the prospect may speak with franchisees who have already invested in the franchise, or the prospect may evaluate the investment during the financing stage of the process.

Franchisor Provided Information and the FTC Franchise Rule

The simplest way to evaluate unit-level financial performance is to obtain data from the franchisor. The Federal Trade Commission permits franchisors to provide information regarding the financial performance of its franchised or company-owned outlets (a Financial Performance Representation or “FPR”), if there is a reasonable basis for the information and the information is included in the Franchise Disclosure Document. When discussing this information, one should always note whether the information given represents gross or net financial data. Should the franchise salesperson or other representative provide earnings claims, be sure to document exactly what was said, by whom, in what capacity, and the time/date/circumstances.

On the other hand, a franchisor is not obligated to provide a prospective franchisee with an FPR. While franchise sales regulators encourage franchisors to distribute information on unit-level financial performance, many franchisors choose not to do so. Common reasons franchisors give for not doing so are listed below:

• They do not have enough historical information to provide an adequate basis for a claim.
• Providing any information could expose them to complaints that the data was misleading.
• They do not need to provide the information to sell franchises.
• Because the data will not show favorable performance.

If the franchisor does not provide unit financial performance data and the salesperson refuses to discuss such information with a prospective franchisee, it is because of the franchisor’s company policy, not because of the FTC rule or any other government policy and/or regulations.

Talking to Franchisees

Whether or not a franchisor decides to disclose unit-level financial performance, an important method of discovering such information – and otherwise investigating a franchise – is to speak with its active and former franchisees. Other franchisees are free to discuss their gross and net financial performance data, as well as other financial information, even if the franchisor does not provide an FPR. Questions one might wish to ask when speaking with franchisees include:

• Is the franchise is meeting the franchisee’s expectations?
• How long after starting up did the franchise become profitable?
• What are other franchisees in different markets saying?
• In the case of a former franchisee, what were the reasons for moving on?

If a prospective franchisee is unable to find current or former franchisees who are willing to discuss their franchises’ performance, it is unlikely that the franchise is a good investment. Moreover, if the only franchisees willing to talk about the subject are those who were suggested by the franchisor’s representative, you may have even more reason to be concerned. Like any survey, in order to provide an adequate basis for your pro forma, you need to talk to a good representative sample of franchisees who are willing to provide specific information on gross sales, costs of goods sold and other expense items.

Checking with the Bank and the SBA

Another method of discerning unit-level franchise performance is to seek preliminary financing approval from a bank, and simply ask the bank to request financial performance data from the franchisor. The FTC Franchise Rule does not apply to a franchisor sharing such information with a bank, as long as the bank does not share the data with the prospective franchisee. While you won’t have direct access to the information, a bank’s preliminary decision to approve financing is a pretty good indicator of potential financial performance. A bank will rarely finance a startup venture unless it appears likely to be profitable.

According to Gerald Baroudi, Senior Vice President of Main Street Lender, LLC (www.msl.com), it is “much harder” to close a loan for opening a franchise if the franchisor doesn’t provide an FPR in its disclosure document. If the franchisor prefers to provide the information directly to the lender, then, in the case of Main Street Lender, the loan office would submit the data directly to the Small Business Administration for it to underwrite the loan, making financing must less likely.

Within the banking realm, there are still more alternatives for a prospective franchisee to obtain information. First, one should check the SBA Franchise Registry (www.franchiseregistry.com). This lists franchises that the SBA has approved as legitimate small businesses. One may obtain an SBA-guaranteed loan to become involved, but only if a lending bank approves your application based on its underwriting. You can contact your local SBA for information on the default-rate on loans that involve the franchise. You can also obtain comprehensive information on the SBA loan franchise default-rates from Coleman Publishing of La Canada, Calif. (www.colemanpublishing.com)

Conclusion

In all investments, particularly starting a business, there is always going to be a certain amount of risk. Starting a franchise, as opposed to starting a business from scratch, may allow you to mitigate a portion of that risk, but it’s important for prospective franchisees to carry out their due diligence and investigate the financial performance of any franchise in which they might wish to invest. Hopefully, one or all of the suggestions above will bear fruit and help make it a little easier to decide whether a particular franchise is a good investment.
David L. Cahn, Esq. is the founder of the Franchise & Business Law Group in Baltimore, Maryland. Jeremy Robinson is a law clerk with the firm. They can be reached at 410-347-9442, or online at www.franbuslaw.com. Franchisee Financial Due Diligence
by David Cahn and Jeremy Robinson
Opportunity World
Published July 2008