Key Financial Considerations to Mitigate Risk when Buying into a Franchise
If becoming a franchisee is your dream, don’t let it become a nightmare. Before prospective franchisees buy into a franchise, they must ensure the endeavor comes with minimal risk and has the potential for profit. This involves reviewing a franchisor’s financial history. Federal and state government safeguards are in place to protect prospective franchisees. However, this doesn’t mean these individuals shouldn’t do their due diligence when evaluating prospective franchisors.
An important decision is to find something you like to do first. Narrow that down into some options and then look at the financials — financial performance representations or financial statements — to determine if it’s a healthy franchise chain and something that you can afford.
When looking at a potential franchise opportunity, start by looking at the Franchise Disclosure Document, a document that the Federal Trade Commission requires the franchisor to put together. This used to be called the Uniform Franchise Offering Circular (UFOC). Historically there were instances when franchisors were taking advantage of potential franchisees. A lot of the information that was coming out was not reliable information. In an effort to protect franchisees, the government created regulation that requires certain items to be input into the Franchise Disclosure Document so that it’s much more transparent for a franchisee.
Inside of the Franchise Disclosure Document, there are two main sections: Item 19, financial performance representations, and Item 21, which is going to contain audited financial statements of the franchisor’s company. These sections both bring potential red flags.
Financial performance representations
A financial performance representation is information about the actual or potential financial performance of a franchise and/or franchisor-owned location. It can be inside of the disclosure document, but it doesn’t have to be. Anything performance-based would be considered a financial performance representation, from something on the franchisee’s website to one of the franchisor’s employees communicating orally to somebody. You can disclose anything as long as it has a reasonable basis and written substantiation.
Examples of financial performance representations include “You could earn $100,000 profit,” or “Generate sales volume of $750,000.” Even “Make enough money to buy a new Porsche” would be considered a financial performance representation because a new Porsche can be quantified.
A general statement like, “This is the opportunity of a lifetime,” would not be considered a financial performance representation.
Audited financial statements
A potential franchisee should check if the audit was performed by a reputable accounting firm and what kind of opinion the auditor issued. Other red flags could include: large swings from year to year in account values, working capital deficiencies, negative equity as a result of too much debt, a downward trend in total revenue, declining profit margins, poor cash flow from operations, and contingent liabilities listed in the footnotes. It’s important to also be mindful of financial performance representations not founded in fact.
Making the decision to open a franchise location can be a very intimidating process, especially for someone who isn’t familiar with running a business. It’s important to figure out what you like to do, consider all your options, review all of the documents that are available to you and make an informed decision.
Watch our video "Value Drivers for Buy Side Transactions" to learn more about due diligence to perform when evaluating prospective franchisors.
To learn more about the key considerations to mitigate risk when buying into a franchise, contact Bryan A. Graiff, Partner in Charge, Transaction Advisory and Litigation Support, at 314.983.1390 or firstname.lastname@example.org.