How to Tell if a Franchise Is a Good InvestmentResearch these five factors to determine if a particular franchise is worth the risk.
When you’re investing a considerable amount of money — your life savings, perhaps — into buying and opening a franchise business, you want to make sure it’s going to be a good financial investment.
If you’ve already taken the steps to determine if a franchise is a good fit for your personality and passions and you’ve vetted the franchise you’re looking at with other franchises in the system, it’s time to examine these five factors to help determine if the franchise will deliver.
Assess performance — and risk
As with any business venture, you need to weigh your return on investment with the risk involved. If you’re particularly risk-averse, for example, a startup franchise in its early stages might not be right for you.
“If you want super high returns, that means high risk,” said Fred Auzenne, CEO of Legacy Franchise Group, a consulting firm in Scottsdale, Arizona. “Early stage companies with a pattern of super growth means you’re taking a risk that the market can sustain that.”
When you’re looking at the franchise disclosure document — many experts recommend you do so with the help of a franchise lawyer — you’ll find information on a franchise’s financial performance on line 19 (also know as “Financial Performance Representations”).
Franchisees consider this the most important line of the document according to Don Daszkowski, founder of the International Franchise Professionals Group. Why? Because it answers the essential question, “How much money can I make?” But, Daszkowski warns, don’t take this as an guaranteed indicator of future performance for your franchise.
“Be careful because this is just a snapshot or a summary of a select few franchises in the system,” he said.
Another way to evaluate a franchise’s risk is to find out failure and turnover rates, according to Deb Scribner, a partner at Posternak Blankstein & Lund, a Boston law firm that specializes in franchise lending.
“Ask whether the number of company-owned stores increased or decreased in the last five years and by how much,” she said. “What is the unit failure rate? What is the franchisee turnover rate?”
Look at litigation history
A franchise that has been sued isn’t necessarily a bad financial investment, but you shouldn’t ignore litigation, either. Item 3 of the franchise disclosure agreement shows pending and past legal actions against the franchise company, from contract disputes to fraud allegations.
According to Auzenne, what you’re looking for here (again, with a franchise lawyer’s help) are patterns.
“We live in the U.S.A. where anybody can sue anyone,” he said. “Look at the number of lawsuits and what the cases are. If you see 10 lawsuits for the same thing, there’s a red flag. And just because some franchises have not been sued doesn’t mean that they’re any better than the others.”
Scribner suggested investigating how the lawsuits were resolved and inquiring with the franchisor about how disputes are handled between franchisee and franchisor (is there an arbitration clause, for example?) to get a sense of what might happen if something goes wrong.
Evaluate the royalties
A key number to look at is the royalty fee, the percentage of your gross revenue that goes back to the franchisor weekly or monthly.
One way to find out if the fee is fair is to ask other franchisees what they’re getting for the money, according to Mike Martuza, president and owner of FranNet of New England, a consulting firm in Beverly, Massachusetts.
“There should be some ongoing benefit to the franchisee, such as product and service development or marketing, that the franchisee wants but would be too expensive to handle on his or her own,” he said.
Consider the hype
For more risk-averse franchisees, the trendy franchise du jour may not be the best investment. According to Cindy Readnower, author of “Straight Talk About Franchising: What I Learned and You Need to Know,” whether you invest in a newer franchise is a matter of your risk tolerance.
“Look at where the franchise is in the life cycle of its business,” she said. “Most up and coming, trendy franchises don’t necessarily have the kinks worked out. You must weigh whether it is better to be with a business that has lots of public attention and is relatively new or one that is tried and true and has a history that you can look at.”
Scribner recommends asking the franchisor about future plans, especially if the franchise is new. “Ask what changes the franchisor sees developing in its space in the next five years and how that will affect its franchisees,” she said.
Buying a franchise may be less risky than starting a business from scratch thanks to the name recognition, built-in customer base and marketing and operational support, but you’ll still want to do plenty of homework to be sure you’re sinking your money into a sure thing, or the closest approximation the business world offers.