10 Key things you need to know before buying a franchise
Published Wed, May 11 2016
8:57 AM EDT
Updated Wed, Jul 6 20161:14 PM EDT
The franchise disclosure document (FDD), the annual filing by a franchise corporation that includes all of the information an entrepreneur will be privy to when considering a franchise investment, can include two dozen sections and run to hundreds of pages. But FDDs all have one thing in common, according to attorney Richard Rosen:
“These documents are pretty long, on purpose,” said Rosen, current chairman of the New York State Franchise Bar Association and a member of the Franchise Times’ “Legal Eagles Hall of Fame.” That purpose is to favor the franchise corporation over the prospective franchisee.
Rosen, who has reviewed countless FDDs during his career while representing hundreds of entrepreneurs buying into franchise systems, said reading these documents in their entirety is essential research, but there are the sections of the FDD that are the most important for entrepreneurs to understand.
1. The territory
The protected territory a prospective franchise will be buying should be defined, and this is crucial. The sheer size of the territory isn’t necessarily the most important thing, and it may vary depending on an urban or suburban setting. It also can be defined by a population size rather than distance. But knowing your territory is among the most important issues to understand before signing a franchise agreement. If no territory is delineated, that can be one of the biggest red flags for a prospective franchisee.
2. Restricted covenants
Many of the things a franchisee can and cannot do, during ownership and after ownership ends, is covered under restricted covenants. A typical covenant for owners would describe restrictions on any competing business interests and a subset might go into how much involvement they are required to have in running the franchise on a daily basis.
The most important covenants often relate to the period after ownership, or “post-term” as it is known. This could include a situation in which the one-time owner is no longer involved in daily operations, has been terminated for default, or has sold the business.
3. Litigation history
For any franchisor that has been in business for a while, the history of litigation is important. Ancillary litigation, or cases involving third-parties such as suppliers, should be noted, but it’s cases against a franchise system’s own franchisees that are the most important legal actions to review for a prospective franchisee.
There is no way to provide a number across the entire franchise universe for how many legal cases is “too many.” If a franchise is a McDonald’s-size company, then hundreds of legal cases may not be a lot. But a franchisor with a total of 500 units and 25 legal cases, for example, warrants scrutiny.
4. Renewal rights
In the best-case scenario, renewal rights to a franchise will be perpetual. But Rosen said the reality is that at most one-quarter of all franchises offer such franchisee-friendly renewal terms, with a current owner always retaining the right to renew. The length of renewal periods after an initial franchise ownership term ends, and how many renewals you are entitled to, is one of the most important contract terms to get right to avoid headaches down the road, especially as a franchise becomes more successful.
5. Franchise company right to acquire units
Many franchise agreements state that at the end of a franchise agreement the franchisor has the right to acquire the assets. There’s nothing wrong with selling your franchise back to the franchisor, as long as the price is right. Consult the specific terms for franchise company acquisition of your business. If the formula the franchisor plans to use to set the acquisition price is referred to as “depreciated value” that’s a red flag.
6. Ownership transfer rights
It’s not just “depreciated value” that can leave the franchisee with a weak hand when it comes time for a sale. Many franchise agreements also include a right of first refusal for the franchisor when a franchisee is selling their business. A franchisor should have a right to take back ownership of one of its business units rather than allow a franchisee to sell to a third party, but only if the franchisor is willing to make a fair deal.
The right of first refusal can create a cooling effect on the market for a franchisee’s business because any potential buyer won’t want to waste time negotiating when the franchise corporation can always come in and assume its right to buy the business. A franchisee may not be able to maximize the sales price in this scenario. It’s wise to negotiate what is called right of first purchase for the franchisor.
7. Estimated initial investment
No surprise: the estimated initial investment and ongoing fees to be paid are critical.
Franchisees don’t need to worry about these costs being missing from a document, but they do need to worry about the costs being understated. An initial cost estimate should factor in the cost of construction, lease security costs for a location, equipment lease costs, and if properly money to be set aside to cover the first several months of operations.
The biggest item that is often under-estimated is the cost of construction and that can lead to legal disputes, Rosen said. The difference between a stated construction cost in the FDD and actual cost can be significant, running into the hundreds of thousands of dollars. “If there is a dispute with a franchisor on failure to disclose initial investment costs, this is a big one,” he said.
8. Financial performance representations
Financial performance representations is a potential area for litigation. Once upon a time it wasn’t even legal for franchisors to share this information, and even with it now being legal many franchisors are still reluctant because they are afraid they will be sued.
But franchisees should look for some indication of the financial performance across every location in the franchise system. Gross sales is limited in value because it does not speak to profitability, but is often all a franchisee can expect to see. Rosen said it is acceptable for the information to be reported anonymously. Some franchisors will only provide a range, for example, by percentage of locations that have annual revenue of between “X” and “Y” level.
A separate schedule in franchise documents showing financial performance for all units is ideal, but anonymously reported revenue ranges, in the least, should be provided. The most common way is still to not provide anything, Rosen said. The best method is, “the more the better, even if it becomes unwieldy,” he added.
Franchisees should also look for a breakdown by geography, and by urban or suburban segments.
9. Dispute resolution
A franchisee should know if the agreement gives them the right to litigate or only seek private arbitration or mediation in the event of a dispute with the franchise company. But most important is who — or who doesn’t — pay.
Whether arbitration or litigation the biggest red flag is if there is no mutuality regarding the responsibilities for payment of attorney fees.
A franchisor can state in an agreement that in the event they sue a franchisee, it’s the franchisee who will be responsible for their attorney fees. But these same statements often don’t stipulate that if the franchisee wins, then the franchisor is responsible for the same payment.
“That distinction is crucial,” Rosen said. The fairest way to design these clauses is that the unsuccessful party, whoever it is, pays reasonable costs and expenses of the successful party. “Litigation is incredibly expensive so many times a franchisee is not in the position to undertake a case because of the cost, and can only hope if their complaint is legitimate that attorney fees will be paid,” Rosen said.
Home turf matters too, as in, who has it. Chances are a franchisee is not going to be able to dictate where any dispute is settled, but if you run a franchise in Hawaii and would need to travel to the franchisor’s home state of Massachusetts for a court date or arbitration, you at least want to know that.
Reading isn’t enough. A critical part of the franchise research process for any entrepreneur or investor is to reach out to current owners in the franchise system. Rosen recommends contacting at least a dozen current owners: “It’s a thing that I tell every prospective franchisee that I represent. Not less than 12 franchisees that are in system.”
Rosen said franchisee contact information is listed in the FDD. Rosen recommends reaching out to franchisees that are not located in the same region as the one an entrepreneur is considering, since this interest could be conceived as a competitive threat. In general, many franchisees will be willing to talk, he added.