To the trained eye, franchise fraud patterns are easily evident. However, far too many first-time entrepreneurs still fall victim to scammers. Why are there so many franchise scams? Well, in my experience, there’s no single contributor to franchise fraud — ease of developing a franchise, absence of common standards in franchise regulations and the way franchises are bought and sold, are a few reasons. But the biggest factor, by far, behind franchise scams is that there are still eager individuals who jump into a long-term commitment without doing their homework, and want to “go it alone”.
COMMON RED FLAGS
1. High-pressure to commit quickly
If the franchisor is pressuring you to sign contracts without allowing you to properly read them first. The franchisor who will not immediately disclose all relevant details to your satisfacion, is probably trying to hide something. The franchise may not be profitable or worse, a scam. You should never feel incentivized to buy a franchise quickly or penalized for delaying your decision, for any reason. Remember that you are making a long-term investment on behalf of your family, and you should be cautious with your decision.
2. Confusing contract
If the franchise agreement seems intentionally wordy, confusing, and in some parts completely nonsensical…before you sign anything, be sure you learn all of the relevant information, make sure your questions are answered fully in layman’s terms and you understand the answers. Consider asking a franchise attorney to review the agreement.
There is always a risk associated with buying a new franchise – or any business, for that matter. Even the franchisor with the most successful concept cannot, by law, promise that you will make a profit. Be wary of those who make loose claims about money that can be made with practically no risk. If the earnings claim is not represented in the FDD under item 19, be wary. As the old saying goes — if it is too good to be true, it usually is.
4. Unjustified franchise fees
Startup fees can sometimes be legitimately high. However, some crooked franchisors have sold franchises and disappeared with the initial franchise fee. You should know whether the initial fees include services or goods that are to be received by the franchisee before the franchise business opens. Beyond the initial setup fees, are you being offered bloated costs for liability insurance, CRM system, billing service and other professional services?
It is difficult to avoid being the target of a fraud if you don’t know the warning signs. Law requires that every franchisor file a Franchise Disclosure Document, which is a document required by Federal Trade Commission (www.ftc.gov) about the franchise opportunity. Make sure that the copy you receive from the franchisor is identical to the copy submitted to the FTC.
1. Speak to your potential peers
It is surprising how many candidates skip this simple but important step in due diligence. Contact existing franchisees with prepared questions. Speak to new franchisees in the system and some that have been around awhile. The million dollar question is: “If you had it to do over, would you do it again?”
2. Online research
Go online and research news stories about the company and the industry. If the company is public, look at their SEC filings on www.google.com/finance. Visit their Web site and get information about their offerings. Compare the company to its competition — both franchised and non-franchised.
3. Franchisor interview
Ask them about the process they use in selecting franchisees. If you get the sense that they don’t select franchisees but are in the business of selling franchises, that’s a red flag.
4. Strength of brand
A franchise system relies heavily on its brand, and that brand is reinforced by how well the other franchisees perform. If the franchisor lets anyone who has money in the system and does not have selection criteria, then your investment will probably be at risk.
5. Visit the headquarters
Most franchisors will invite a candidate to visit their corporate office before awarding a franchise license. Don’t attend an event until the majority of your due diligence is complete.
6. Relevant experience and management expertise
Does the company have experience in the business being offered? I’m not talking about a related business, but the exact business. Does management have a history of success? Does the franchise management know how to operate your business successfully? If not, what type of support are you likely to get? In general, a mix of executives with experience in the business and as successful franchisors is a great benefit to franchisees.
7. Financial review
What is the financial strength of the franchisor? Your investment will probably be significant. Does the franchisor have skin in the game? Do they have a history of profitability? Are they earning their revenue from royalties and other continuing sources of revenue, or are they relying primarily on the sale of the next franchise for their own cash flow? Ask the other franchisees in the system if they got value for their money. (Keep in mind, though, that franchisees new to the system may not even know yet.)
What’s the franchisor’s litigation or regulatory history? Franchisors must disclose relevant litigation. Sometimes litigation is good. Any franchisor that enforces system standards will occasionally need to sue its franchisees. If they’re able to still maintain a good relationship with their other franchisees, that type of litigation is an indication of a strong and responsible franchisor because it limits your risks due to the actions of other franchisees. However, if there is a long history of lawsuits from franchisees listed in the disclosure documents, that’s not a good sign. You need to understand the basis for the lawsuits and make a decision based upon the facts. Your attorney or advisor can help you analyze the franchise litigation.
Thousands of attractive franchise opportunities are available today, and there’s absolutely no reason for you to settle for less than the best opportunity to match your lifestyle, risk tolerance and investment range. There’s a lot you can do to protect yourself from franchise fraud. The franchisor is required to provide you with a disclosure document. The disclosure document is an important tool for prospective franchisees to do their own due diligence.
If this is your only experience with franchising, your best bet is to have the assistance of a qualified expert. An experienced franchise advisor or consultant has the advantage of having been through the selling process many times. Having operational and training experience with different franchisors is something many franchise advisors lack, so ask about their experience. Sometimes, as in my case, this expertise comes at no out-of-pocket cost to the client. However, if you do go it alone, use this guide to substantially reduce your exposure to franchise fraud.
Best of luck!