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Franchise Affiliation By Andrew Adama
All the things you need to know about franchise affiliation...
Eyes wide open You've met with sales representatives of a franchise todetermine whether affiliation with the system might benefit yourcompany. But it's a big step. Taking it requires you to make amajor upfront financial investment--in franchise fees, newsignage, maybe even a different color on your office walls--andit commits you to payments going forward, including monthlyroyalties and contributions to an advertising fund.
Then there are the low-probability but high-impact events toconsider. What if the franchisor becomes embroiled in ahigh-cost, high-profile lawsuit? Even if the matter doesn'tdirectly involve you, you're affected. For good or ill, yourcompany's brand identity is now linked in the minds of consumersand your business partners to that of the franchisor. Given the high stakes of affiliation, you must enter into afranchise agreement with your eyes wide open, something federaland state regulators want to make as easy as possible. TheFederal Trade Commission and some states require franchisors toprovide you a wide array of information upfront--an accountingof pending and closed lawsuits against the company, for example,and details about your initial investment and ongoing fees--tohelp you make an informed decision about purchasing a franchise.Franchisors are also required to provide the information in astandardized format, in a document known as the uniformfranchise offering circular or UFOC. But knowing a franchise brand intimately is easier said thendone. The UFOC is an imposing document that, with attachments,can run hundreds of pages. What's more, some of the keyoperational information you need to conduct your duediligence--what are the franchisor's rules on record keeping,what are its policies on signage?--might be hidden away in thecompany policy manual rather than in the UFOC. Since companiescan change the policies in their manual at any time, thesechanges can impact your bottom line if they result in unforeseencosts to you. What's more, companies aren't obligated to show you their policymanual because it's an internal document. Some will let you lookat it but not take it with you, making a thorough reviewdifficult.So, how do you cover your bases before entering into a franchiseagreement? First, know the principal question you need to answer: Does the value I receive from affiliating with the franchisor'sbrand identity, advertising muscle, training program, andbusiness process offset the economic investment I'll make andthe operational control I'll give up? Second, do your due diligence. You can't answer that questionwithout first digging into the UFOC. All UFOCs include a tableof contents to help you review the document by section. 10 due diligence steps Review the UFOC with an eye toward theissues affecting your financial investment and the amount ofcontrol you'll relinquish. Among the issues to consider: 1. Entry and exit costs. How much will it cost to convert youroffice? The UFOC requires disclosure of these costs, butfranchisors typically provide a broad range--in real estate, aspread as wide as $21,000 to $250,000--making it hard for you toknow what your costs will be. The reason for the range: Your costs are unique. At the veryleast, you'll need to change your signs and letterhead and paythe initial franchise fee, among other things. But you may alsoneed to add or upgrade equipment or hire additional staff. Then there are exit costs. How much will you incur in"de-identification" and other conversion costs to leave thesystem? Exit costs aren't included in the UFOC, so you have toestimate them yourself. 2. Ongoing value. You face monthly royalty payments; otherregular fees, such as for referrals (independent companies canchoose whether to belong to a third-party referral group--in afranchise, belonging to the referral group is part of theaffiliation); and indirect costs. If the franchisor imposesmandatory training on you, for example, you might have to absorbyour travel costs if the training is off-site. For all these ongoing costs, what value will you receive? Arethe referrals worth the fees? Is the training worth the cost?Will the franchisor's affiliated businesses--perhaps it owns afinancial services company--drive customers to you that youotherwise wouldn't get? Conduct a cost-benefit analysis,examining your additional monthly costs against the additionalincome you expect to receive to get a picture of the value ofjoining the brand. 3. Earnings claims. Franchisors aren't required to disclose howmuch they think you'll earn; nor are they required to give youhistorical data on their franchisees' earnings. If thefranchisor doesn't report its franchisees' earnings in theUFOC--and most don't--ask why it doesn't. After all, thefranchisor requires its franchisees to report their earnings, soit has the data available. 4. System growth. Is the number of franchisees growing orcontracting? Is the number of company-owned operationsincreasing or declining? This may be the most importantinformation you review. A declining or stagnating number offranchisees (and a growing number of company-owned offices) maysuggest that the system isn't healthy. A high number ofterminations or non-renewals may also be troubling. The UFOC requires franchisors to disclose this data for thethree most recent years, but it can be hard for prospectivefranchisees to identify turnover rates in the system because thenumbers are disclosed in aggregate for the entire franchisenetwork. If, in a given year, a franchisor loses one franchiseein an area but gains a replacement franchisee, for example, thedata would show no change for that year, suggesting a stablepicture. But is the system really stable? For your purposes, itmight be more important to know why that one franchisee left. 5. Franchisee input. The most valuable research you can do is totalk with existing and past franchisees, whose contact info theUFOC requires franchisors to disclose. The best question to askthem: If you had to do it all over again, would you do it? In general, franchise agreements contain confidentialityprovisions that restrict franchisees from talking about mattersproprietary to the system, such as internal business processes.What you're looking for, though, is a subjective assessment fromthe franchisee that the system's value proposition issound--that is, the benefits you get from affiliating exceedyour costs to belong. Seek input from past franchisees, too, but be aware that brokerswho've left the system tend to be those most unhappy with it. Soweigh what they say with that in mind. Also, if the franchiseeshave an association or if the franchisor maintains a franchiseadvisory council, talk to the leaders of those bodies. Veryoften, they're among the most widely respected and long-standingfranchisees in the system, and they bring historical knowledgethat may surpass even that of some of the franchisor's employees. One important point: In real estate, unlike in many otherindustries, franchise agreements tend to come withoutpost-expiration non-compete clauses. That's good for franchiseesbecause, if they opt not to renew their franchise agreement,they can convert identities and continue operations withoutskipping a beat. Franchise systems in many other industriesdon't permit ex-franchisees that same freedom. Given thisflexibility, you can expect real estate franchises to havehigher turnover rates than franchises in other industries, allelse being equal. 6. Litigation. The UFOC requires the franchisor to disclose allits pending and resolved lawsuits for the last seven fiscalyears. Compare its number of lawsuits (those it has initiatedand those against it) with its number of franchisees. There's norule of thumb for what constitutes a high ratio of litigation.But it's probably safe to say that a franchisor with 1,000franchisees and three pending lawsuits isn't overly litigious. Also look at how the franchisor responds to lawsuits. Does itsettle quickly or does it tend to go to the mat each time? Areading of the UFOC will show you how the franchisor approachedeach suit because the UFOC requires the franchisor to provide anarrative for each. How the company responds can tell yousomething about its character and culture. Note what the lawsuits tend to be about. Is there a pattern? Asa general matter, many lawsuits are initiated by franchisorsagainst franchisees for non-payment of royalties and fees. Butlook below the surface. In some cases, franchisees don't paytheir fees because they feel they aren't getting the value theywere led to believe was there. The narrative describing eachsuit should provide the argument for any counter-charges by thefranchisee. To supplement that information, talk to formerfranchisees. 7. Franchisor personnel. Look at who the franchisor's topexecutives are. That information, usually in the form of shortbiographies, is required to be in the UFOC. Pay particularattention to executives who've come from other industries. Somesystems are historically more litigious than others. Onesandwich chain, for example, is generally recognized as highlylitigious. It's helpful to know if an officer comes from such asystem. If so, that officer might be quicker to resort tolitigation to settle a matter than another officer. To learnabout other franchises, contact a franchisee association,attorney, or accountant. Other things to look for: 1) Nepotism. Are franchise operationsmanaged by family members? If they are, the best people mightnot be in management positions. 2) Bankruptcies. Have any of thetop executives been involved in bankruptcies in other systems?Contact franchisee associations, attorneys, or accountants tofind out. 8. Exclusivity. How much protection do you have fromencroachment into your territory? Does any exclusivity you haveextend to Web site marketing and relocation referrals? You knowyou'll be competing with other brokerages, franchised andindependent. But could the franchisor you're considering joiningbe among your competitors as well? 9. Financials. The UFOC mandates disclosure of franchisorfinancial statements for the previous three years. Show these toyour accountant. One thing to look for: Where is the franchisorgetting the bulk of its income? If it's from initial franchisefees rather than royalties, that could signal turnover amongfranchisees. A more promising picture is a company whoselifeblood is royalty income. That signals income from ongoingoperations. 10. Sloppiness. For franchisors, complying with UFOCrequirements can be costly. These pre-disclosure documents arecomplicated and extensive. Signs of sloppiness--miscalculations,misspellings, internal inconsistencies--should raise concernsthat the franchisor isn't devoting proper resources to a veryimportant task, one with legal ramifications. Besides typos, look for inconsistencies. For instance, afranchisor might disclose the number of franchisees in as manyas three different parts of the UFOC. These numbers should bethe same in each case. If they're not, what does that say abouthow careful the company has been in preparing the UFOC and howmuch in the way of resources and competence it brings to itsoperations in general? The title page of the UFOC pointedly recommends that prospectivefranchisees review the UFOC with an adviser, such as an attorneyor accountant. But take time to conduct your own careful duediligence as well. Proceeding with your eyes wide open can makethe difference in how much your company benefits from afranchise affiliation. ----------------------------------- About the author:Andrew Adams writes for http://www.magfranchise.orgwhere you can find out more about franchising and othertopics. Back to Franchise Article List
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