Franchise Danger Signals

WSJ:

1. Lots of litigation and closures
The offering circular, which is being renamed the franchise disclosure document, is packed with information to help assess the offer, including backgrounds of the company executives, bankruptcies, ongoing royalties and start-up costs franchisees will pay, earnings claims and other financial information.

But two pieces of information are particularly useful. Franchisers must list all the litigation they’ve been involved with over the past 10 years. A lot of litigation — especially a suit that several franchisees have joined — means a number of franchisees have been disgruntled enough to take action, says Stephen Story, a franchise lawyer in Norfolk, Va.

Another number to check: the percentage of franchises that have closed or been sold back to the franchiser in the past five years. A total rate of more than 5% or 10% in one year could mean many franchisees became disgruntled or unprofitable.
You should also compare the start-up costs, franchise fees and ongoing royalties charged by the franchise to other similar franchises by checking their offering circulars.

2. Too many bad reviews
Interview at least a dozen current and former franchisees, preferably more. The disclosure documents provided by the franchiser must include a list of all current franchisees in your state along with all franchisees who’ve terminated, canceled or not renewed their franchise agreements in the most recent fiscal year. Make sure that some of the current and former franchisees you call are in your geographic area.

Ask how responsive the franchiser has been to questions and problems, and how much support the franchiser has provided in marketing help and supplies. Also inquire how profitable the franchises have been compared with the franchisees’ original expectations.

One bad review, of course, may just be a case of sour grapes. But if you receive a handful of bad or lukewarm reviews — or little commentary at all — you might want to rethink the offer, says Mark Siebert, chief executive of iFranchise Group, a Homewood, Ill., franchise consulting firm. “If those franchisees were surprised with the negative results that they achieved, then you likely will be, too,” he says.

3. High-pressure sales tactics
It’s a bad sign if the franchiser pressures you to buy quickly, says Mario Herman, an Adamstown, Md., lawyer who represents franchisees.

A franchiser might, for instance, tell prospective franchisees they have a short window of time before the current franchise offer expires or ask for a down payment to hold a particular location.

“You should not have any money exchange before you have time to fully review the offer,” Mr. Herman says.

4. Ambiguous termination clauses
What happens if your franchise fails three years into your 10-year franchise agreement?

You better know the answer before you sign. Sometimes the franchise agreement explicitly lays out the termination procedures, but other times the terms are ambiguous or even very unfavorable.

Some franchisers have sued former franchisees to collect future royalties or tried to prevent them from running a similar business anywhere near where the franchise was located, Mr. Herman says.