Key Red Flags to Tackle During The Franchise Due Diligence Process
During due diligence, as you are assessing franchises, it’s paramount to acknowledge and address red flags. Below is a discussion of some of the predominant warning signs that should cause you to conduct a deeper and more thorough due diligence into particular areas of a franchise to assess the actual risk.
There are a number of issues that can arise from Item 19, the financial representation portion of a Franchise Disclosure Document (FDD), and Item 7, the estimate of the initial investment range.
1. Item 19 Issues
Item 19 is the section of the FDD where franchisors must disclose their financial performance representations. First, there may be no financial disclosure or it may be so vague as to possess no value. There are several reasonable explanations for this, such as how the brand structures royalties and does not track financial performance. However, it is important to understand why there is no financial performance and to dig more deeply as you’re doing validation calls. You must confirm that your financial expectations can be met.
Secondly, the financials, as expressed in Item 19, may exhibit low revenue or income performance relative to your expectations. It is here where you want to gain some clarity and access the risk. Address concerns with both the franchisor and franchisees to learn why the numbers are low. There are several fabulous brands whose numbers are low because they either have franchisees with less tenure than others or their model has evolved and is more effective than it has been historically. It is important that you explore the why.
Newer franchisors will often rely only on corporate locations for their Item 19 financials. They do this because they do not have any existing franchise locations that are reporting. However, in my experience, corporate locations almost always outperform franchise locations, often significantly. Therefore, you will want to dig in deeply and truly understand whether or not you will be able to duplicate the performance of the corporate location.
2. Item 7 Issues
Item 7 of the FDD requires franchisors to estimate the initial investment. When you are exploring a brand whose estimated initial investment is significantly less than its peers and your expectations, it is important to validate those numbers with franchisees. In my experience, brands that have Item 7 that appears low often have franchisees who spend much more than the higher end of their Item 7. In other words, Item 7 may be low and your actual cost may be much higher. This is particularly true in new franchises where the only locations are corporate, and therefore the actual cost of entry can’t be accurately validated. Be careful!
3. Emerging Brands
Emerging brands often provide great opportunities but are riskier than their established competitors. First, they lack true validation, so you will not necessarily receive valuable feedback about the brand from franchisees. With emerging brands, most of the franchisees are new to the system and cannot provide much guidance. In addition, emerging brands rarely have a turnkey business model that many expect in a franchise. Accordingly, it is important to delve deeply into the model and verify the brand can support you in the manner you require and expect.
4. Sold-to-Open Ratio
Franchise brands can be hot and grow rapidly. While this may at first blush seem like a positive, it is bad when the brand is unable to launch and support its existing and new franchisees appropriately. Begin by comparing the number of units sold to the number opened. If there is a significant discrepancy, seek guidance from the franchisor on how they plan to open locations. Gain assurances that yours will open in an appropriate time frame. It is easier to sell franchises than to open them and you don’t want to be whipsawed in a brand that cannot open the units it sells.
5. Franchisee Needs To Fill The Sales Funnel
Generally, there is greater risk in franchises that rely on proactive franchisee sales outreach. This makes sense because not everybody is a sales hunter. Anytime I present my clients with a brand that requires the franchisees to fill the top of the sales funnel, I am very clear in explaining the added volatility of such models. Understand what is expected of you and be exceedingly comfortable and honest about your ability to execute.
These are some of the warning signs that need to be addressed during franchise due diligence. To be clear, none of these points are reasons not to join a franchise. However, they are reasons to dig more deeply during the due diligence process. Happy franchising!