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Due Diligence In Acquiring A Franchise

In this era in which our economy is dominated by large business concerns having the ability to realize profits through potent marketing, high volume sales and low margins, one of the most effective ways for the individual small entrepreneur to fulfill his or her "American Dream" of owning a business is to acquire a franchise. Franchises often provide the benefit of instant name recognition, national advertising, cooperative purchasing arrangements, effective training, site location and ongoing operating assistance. Indeed, lenders are often more willing to make start-up business loans to franchisees of well-known franchises than to those who propose to operate similar businesses without the benefit of a well-known franchise. Nevertheless, the acquisition of a franchise usually involves a substantial investment and the assumption of a substantial degree of risk by the franchisee. Therefore, as with any substantial investment, a prospective franchisee should carefully consider many factors before acquiring a franchise. The following is a brief outline of some of the matters which should be considered before acquiring a franchise:

  1. The Franchise Offering Circular. The Federal Trade Commission and many state-level franchise laws require franchisors to provide each prospective franchisee with a "franchise offering circular" at least 10 days before being asked to sign any contract or pay any money to a franchisor. The franchise offering circular should be reviewed carefully by the prospective franchisee and his or her professional advisors. The offering circular will contain information about the franchisor, its business executives, any litigation between the franchisor and other franchisees, and the material terms of the franchise agreement. One important aspect of the offering circular is information about current and former franchisees. A prudent prospective franchisee will contact as many current and former franchisees as possible to discover whether other franchisees have had problems with the franchisor or whether their performance has fallen short of expectations. Contacting franchisees who have terminated their franchise relationship can be very enlightening.
  2. Cost. Most franchises include an initial non-refundable franchise fee which may range from several thousand dollars to several hundred thousand dollars. In addition, a prospective franchisee should expect to incur significant additional costs relating to establishing and operating the franchise, as well as continuing royalty payments. A prospective franchisee should carefully identify all of the direct and indirect costs of establishing and operating the franchise before making a final decision to acquire a franchise. I have always found it worthwhile to calculate the maximum liability of the franchisee in the context of a business failure in the first year of operation so that the franchisee is well aware of the financial risk associated with a worst case scenario.
  3. Operating Restrictions. All franchises restrict the manner in which their franchisees operate their businesses. These restrictions may include limitations as to supply sources, the types of goods or services which may be offered for sale, customers to whom goods or services may be offered, the territory in which goods or services may be offered, and the frequency of upgrading facilities in accordance with the franchisor's specifications.
  4. Term. The length of the term of the franchise is critically important to the prospective franchisee, as the franchisee needs the time necessary to recoup his or her initial investment and to realize his or her long term business objectives. The franchise offering circular should disclose the conditions under which the franchisor may terminate a franchise and the conditions under which a franchisee may renew, sell or assign the franchise to other parties.
  5. Training. One of the tell-tale signs of a successful franchise is a solid training program. Before acquiring a franchise, a franchisee should be certain that the training program is well established and that there will be adequate technical, business management and marketing training, both at the inception of the franchise relationship and on an ongoing basis.

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