Look Before You Leap: Due Diligence By Prospective Franchisees

by Jeffrey M. Goldstein, Esquire

It’s important that prospective franchisees perform a comprehensive due diligence before purchasing a franchise. This article by franchisee attorney, Jeffrey M. Goldstein, provides insight into this important subject.

Many times a week potential franchisees call me and ask the question: How do I investigate and select the ‘right’ franchise? The answer to this question is challenging, as the answer has both business and legal aspects to it. Since I am a franchise attorney, representing only franchisees, I respond by providing my legal expertise, and also point callers to a few comprehensive business books written by experienced franchise consultants. One of these valuable books is The Franchise Buyer’s Manual by Ed Teixeira.

As a franchise lawyer specializing in complex commercial litigation, specifically franchise law, for almost 30 years, I am readily able to identify the types of information that franchisees should obtain before deciding to purchase a franchise. The ability to identify these critical issues arises primarily from  having practiced before  courts around the country representing franchisees and seeing how these courts have embraced – or rejected – the arguments of both franchisors and franchisees during franchise litigation.

One does not need to be a lawyer or a business consultant; to understand that evaluating a potential franchise requires a full and thoroughgoing understanding of the franchisor company, its industry, its methods, operations, and  rules, among other things. A good road-map to follow is the one I use myself in guiding potential franchisees. Below is a list of the major items that need to be investigated during the potential franchisee’s due diligence.

How do current and former franchisees view the franchisor? Information and opinions from current and former franchisees, the extent you are able to get a trustworthy assessment from them, will be the best source of the most worthwhile information about the franchise and the franchisor.

What is the bottom-line total investment that a new franchisee must make to get the new franchisee up and running? This amount is not merely the ‘initial franchise fee’, nor is it the initial franchise fee supplemented by a month or so of ongoing royalty and marketing payments. Focusing on these fees alone will lead a prospective franchisee to having a false sense of financial security, which could lead to huge economic problems from the very first months of the franchise. Very generally, the new franchisee must determine during due diligence the amounts of investment that will be required to purchase equipment, inventory, and advertising. The prospective franchisee must also determine the amounts of marketing, security deposits, legal fees, grand-opening costs, and variable expenses that will be incurred until a break-even point is achieved.

What assistance and training does the franchisor provide to its franchisees? The investigation of this matter should focus first on the training provided by the franchisor before the franchisee is permitted to open his store or location and on the tutoring and assistance provided after the franchise opens and is operating. One very important question concerns the qualifications of the person or persons who will be answering questions and providing assistance to the franchisee on an ongoing basis. Another vital issue is whether the operations manual published and provided by the franchisor is easy to follow and understand and does it seem fair? A related issue is whether the franchisor’s product or service is so unique that it cannot be developed by the potential franchisee without having to purchase the franchise.

Does the franchise agreement provide the franchisee with any geographical or other type of exclusivity? If so, it is important for the potential franchisee to understand that it is still possible that the franchisor will retain for itself in the fine-print of the franchise agreement the right to sell or market to certain types of accounts or customers even within the franchisee’s protected market. Just as important is for the potential franchisee to determine whether the franchisor has reserved to itself the legal right to itself market and sell through other channels of distribution (e.g., internet).

What is the term of the franchise and does the franchise agreement allow the franchisee to renew at the end of the franchise term as a matter of right? In determining whether there is sufficient return for the initial investment that the prospective franchisee must make in getting the franchise up and running it is crucial for him or her to determine with certainty the ‘payback’ period during which the franchisee can recoup his or her investment. Many state and federal franchise laws impact on this issue. Also of great import are the very explicit conditions set forth in the franchise agreement that impose any type of prerequisites that the franchisee must meet in order to have the right to renew the franchise at the end of the franchise term. In this regard, it is imperative to determine who – the potential franchisee or the franchisor -- has ‘control’ over each of the preconditions.

The legal issues involved with a potential franchisee’s due diligence of a franchise opportunity are broad-spanning and complicated. For instance, just with regard to the single issue of exclusive territory, I would estimate that over 60-75 percent of cases in court and arbitration have involved this issue. And, with regard to duration of the franchise agreement – terminations and renewals – I would estimate that close to 80 percent have involved this matter. These issues, in turn, pivot off of a legal reading of the fine-print in the relevant franchise agreements as well as an interpretation and application of applicable state franchise laws.

As with every business, a franchise business is not immune from the regular business cycles and the other market vicissitudes that are inherent in our free market economy. Franchise agreements do not guarantee success, nor do franchisors usually tell potential franchisees that success is guaranteed. However, it is also important to understand that there are franchises that do allow small entrepreneurs the opportunity to succeed as businessmen. These opportunities, however, cannot be identified without a potential franchisee’s putting in the time, money and effort to properly identify such franchises.

Jeffrey M. Goldstein is a nationally recognized franchise lawyer specializing in franchise law and represents franchisees around the country in due diligence investigations of prospective franchisors, as well as in court cases, arbitrations, and mediations. Mr. Goldstein is the founding partner of Goldstein Law Group, and is the Chairman of the Firm’s Franchise Department. You may reach him at jgoldstein@goldlawgroup.com and via www.goldlawgroup.com