How to Evaluate a Franchise

Yes, franchise locations are increasing dramatically. Yes, franchising will be a strong growth area this decade. But no, franchising is not for everyone. 

Not all are of equal quality. Like other entrepreneurial opportunities, franchising can be a gold mine–or a minefield. 

Complete a thorough "due diligence" before investing in such a business. Here's a partial pre-investment checklist: 

  1. Develop an understanding of the geographic regions where the franchise operates. One risk of expansion is moving the concept into regions where lifestyles or ethnic composition may be different from areas where the franchise now operates. Not all franchise concepts adapt profitably to every part of the country. 
  2. Ask for volume information by region. This will improve your understanding of any "regional revenue bias" that may exist. 
  3. Seek information on volume by year location opened. You'll learn what volumes new locations experience-especially important to early cash flow analysis. An understanding of volume levels in two-, five-, and 10-year-old installations will also be useful in predicting success. 
  4. Ask the franchisor to provide, for the last three to five years, the number of locations operating at the end of each fiscal period. 
  5. Seek opening and closing data for the last three fiscal years. This takes your inquiry beyond the number of locations operating. For example, a franchisor may show it had 100 locations open at the end of the last fiscal year. One year later, it has 110 operating. Did they open 10 franchises? Not necessarily. They may have opened 20 and closed 10. There's a big difference. 
  6. How many locations does the franchisor operate? Usually, but not always, the best franchising opportunities exist where the franchisor operates at least 10 percent of total locations. This number is often 20 or 30 percent. This is a good indicator of their operating knowledge, their belief level, their financial capacity, and their management depth. 
  7. How successful are the company-owned locations? You will garner critical information here. Ideally, company-owned locations should be showcases for the franchise. Visit them. If they're not up to your ideals you may want to scratch this company from your prime list. The best franchisors lead their system. You should be concerned if you don't find such leadership. 
  8. How many locations has the franchisor bought from franchisees? If the franchise is more than 10 years old the answer you want is "yes, some were purchased." If none have been, determine whether they're in a financial position to purchase, should the opportunity present itself. The franchisor's ability to purchase is critical for several reasons.
    One of the most important surfaces when a major franchisee wants to sell. The integrity of the system is solidified when the franchisor's position is that of a potential buyer-if only to provide assurance that this large, important operation doesn't fall into the wrong hands.
    Top franchising companies occasionally buy out their larger and stronger franchisees. There are reasons. It provides stability to the system and prevents the franchisee from going out on his or her own, a temptation for larger and more sophisticated operators. It also benefits the morale of smaller operators, motivating them to grow and prosper because the acquisition gives them a vision of the wealth that success may bring.
    A franchisor with financial strength and operational credibility is an important asset. The last concern a franchi- see needs is for a nearby operator to run a business outside of franchise requirements, and not have a franchisor strong enough to deal with the problem.
    As AT&T used to say, "the system is the solution.” Maintaining conformity of product, service, and image within the system is what you're paying for. Find a franchisor with the financial and management teeth to provide it.
  9. Discuss market penetration within the Area of Dominant Influence (ADI). Site selection needs are changing dramatically. The most successful franchise entrepreneurs, now and into the early part of the 21st Century, will organize their businesses with marketing economies and management efficiency foremost in mind.
    For example, if you're entering the retail food industry, an important inquiry relates to how many locations the franchisor has within the ADI–a term referring to the geographic area served by dominant radio and television signals. If you're the only one around, you may not be able to afford the high media costs required for success.
    On the other hand, if there are already many operating locations within your ADI you can cooperatively pool your funds and have immediate media muscle. It is especially beneficial to have a large and successful franchisee operator in your ADI to provide marketing leadership and an opportunity to network on your road to success.
    Promotional clout and managerial efficiency are critical to achievement in franchising. Have a plan that provides you both.
  10. Gather complete financial information. Franchising has full-disclosure requirements, but seldom does that include examples of profitability. Franchisors will play this down, but be persistent in securing pro-forma financial statements. Only the persistent get financial information adequate to make a good decision. Be particularly sensitive to return on sales (ROS) and return on investment (ROI). 

Talk to other franchisees. Important information and a good perspective may come from existing operators. Don't sign up without it.

<< PreviousNext >>

Get the Habits of Wealth

Enter your email to receive all 111 Habits of Wealth sent directly to your inbox.