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Ten tips for franchise due diligence
11/13/09 - Christa Hoyland
Marianne Cintron of Glendora, Calif., thought she had done her homework. When she and her husband looked into buying a Cold Stone Creamery store from a franchisee last year, she started by trying to talk to a number of current franchisees.
Of the five who returned her calls, four were selling their stores. Despite the unusually high percentage of sellers, Cintron was reassured by the good things most of them had to say about the concept.
When she investigated her potential location, she was concerned about several empty storefronts nearby. But the franchise broker assured her that leases had been signed.
She believed the seller — a ranked local fireman whom she respected — when he said she was receiving a successful store with equipment in good condition and a well trained staff.
Although Cintron and her husband had good credit, several banks turned them down because the selling price was too high. Still, the couple was sure they were getting a good deal and eventually received a $350,000 loan to take over the store in Claremont, Calif.
Once inside the store, the rosy picture that had been painted turned out to be a smokescreen hiding a harsh reality.
When the economy turned sour, not only did those leases for nearby stores not materialize, but more stores along the thoroughfare also closed. The store turned out to have a display case full of expired cakes and a broken refrigerator — and was one bad report away from having its franchise revoked.
And the experienced staff? The hourly workers were all ready to leave for college, and the manager left because the Cintrons couldn't cover the cost of her daycare expenses, as the previous owner had.
"They gave us this great story," she said. "But really we were set up to fail."
The Cintrons tried for six months to get the store going, turning to their retirement to pay the bills. But the unexpected challenges couldn't be overcome. They declared bankruptcy and are still fighting a lien on their home. As a result, they hold a deep bitterness toward Cold Stone and the seller. They are now working with Cecil Rolle of Alachua, Fla., another former Cold Stone franchisee, who is trying to organize a class action lawsuit against Cold Stone.
The Cintrons' experience is certainly disheartening — and a hard lesson to learn from. Others can save themselves such heartache by making sure to dig a little deeper.
Christine Friedberg, director of sales innovation for franchise information services provider FRANData, said that doing one's due diligence before buying into a franchise is necessary. It requires a lot of time and effort, but ending up with a successful concept is worth it.
"Every business opportunity is going to advertise it and give you a sense that this is a beautiful business opportunity that you're getting into," she said. "But you really need to know no one's going to give you all the details.
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Too many potential franchisees get a false sense of security from reading the franchise disclosure documents. "A lot of people think, especially because the FDD is such a big legal document, that all the answers are there. But the franchisor's only going to disclose what they have to," she said.
Friedberg suggests potential franchisees take these 10 steps when doing due diligence:
1. Talk to high-performing, middle-of-the-road and low-performing franchisees — "Make sure you get the whole gamut," she said. More importantly, find out how closely the high-performing stores are following the franchise model. And learn what's keeping the low-performing stores from succeeding. When you sign your franchise agreement, emulate those best practices and avoid the poor ones.
2. Talk to franchisees that have left the system in the past couple of years — "Turnover isn't always bad," Friedberg said. "Some franchisees leave the system just because they're in a different place in life or they're moving." Learn why they left and if applicable, why they weren't performing.
3. Take a close look at the number of franchisees selling their units — The average turnover in a franchise system is about one in every 10. "If you pick a random 10 franchisees to talk to and four or five of them are in the process of selling, that should (bring) up a red flag for you," she said.
4. Visit company headquarters — Talk to the company's management about plans. More importantly, be alert to the company's culture. "Just being in the building and getting a feel for culture … is important," Friedberg said.
5. Compare brands — Look to see which concepts are outperforming and underperforming the brand in which you're interested. Learn why the brands are performing differently. "Really take a look at the overall industry rather than just that specific company," Friedberg said.
6. Study the location — Sit in the parking lot and observe. Take notes on the numbers of people driving by, and pay attention to the number and type of customers stopping in. "(Some) very sophisticated organizations take the sit-and-watch approach," she said.
7. Carefully read and fully understand the franchise disclosure documents and franchise agreement — "I'm surprised at how many franchisees glance over it, just because it seems so cumbersome," she said. Be sure to have your financial and legal advisors go through it carefully as well.
8. If considering purchasing an existing unit, ask for the owner's financial statements for the last three to five years — Potential franchisees looking to build their own unit don't necessarily have the right to such information from the franchisor. (Publicly held franchisors have their quarterly financial earnings reports posted on their company Web sites.) Too many buyers don't realize, however, that they have the right to such information from the seller, she said.
9. Talk to neighboring shop owners — Find out traffic patterns and how business is going for them. If there are vacancies on the street, find out why. If things are booming, find out for how long. You'll likely learn more about the area because they don't have a vested interest in your business.
10. Trust the experts, not family and friends — With the holidays and family gatherings around the corner, don't let 'Uncle Harry' talk you out of a good company simply because of his bad experience. "Don't do your due diligence with friends and family over Thanksgiving dinner," Frieberg said.
