What to Know Before Buying a Franchise?

What to Know Before Buying a Franchise?

By: Tom Spadea & Anthony Lopes of Spadea Lignana Attorneys at Law

Introduction to Franchising

If you are considering going into business through the purchase of a franchise you have to first ask yourself if your personality, background and temperament are a fit not only for the franchise system you are considering but for franchising itself.  Franchisees join a team, they are not in business by themselves.  For entrepreneurs that like to tinker, change and break the rules, franchising might not be a good fit.

Although you are “buying” the franchise it is sometimes more helpful to think that you are actually just “renting” the business model.  Take the analogy of the renter of an apartment over the owner of an apartment.  As a renter, you will be responsible for paying the rent, some minor upkeep and you will be allowed to enjoy the space in mostly the same manner that an owner, however you have boundaries to that enjoyment and use.  You can’t destroy the apartment, knock down walls or allow people to live in the apartment that haven’t been approved by the owner.  What you do get however, in exchange for giving up some of the rights of full ownership, is the ability to get into a space in a desirable location for a much lower financial investment and much quicker than you would if you were to buy an apartment or build a house from scratch in the same area.

In a similar manner, franchising allows you to step into a business model that has been proven over time, allowing you to maximize your capital and potentially shorten the time to positive cash flow.  An independent business owner who doesn’t have the support or experience of a franchise system must learn all the things the franchisor has learned over years of trial and error.  By paying a fee upfront and ongoing royalties, the franchisee has a “partner” in the business that can help them reach their goals more efficiently.   This is especially important for a foreign buyer who is considering opening a business in a new country.  Franchising is a great way to be directly integrated into a new culture by using the collective experience of the system as a guide.

Franchising | Legal Considerations

From a legal standpoint, franchising is essentially a license agreement of a franchisor’s trademark, processes and experiences, which is all known as the franchisor’s Proprietary Information. You pay a fee to use that Proprietary Information and agree to use it in accordance with the rules and regulations of the franchisor.  The franchisor will ask you to sign a Franchise Agreement, which is the contract that binds you to the franchisor.  A typical Franchise Agreement is a 60 to 70 page contract that covers everything from the fees that have to be paid, social media policies, resolving disputes between the parties and a myriad of other topics.  It is a very serious legal document that should be fully reviewed by an experienced franchise attorney and understood by all parties before it is signed.

Franchise Disclosure Document (FDD)

In the United States, franchisors are required to give the Franchise Agreement to any prospective franchisees to review, at least 14 days prior to execution, included in an up to date Franchise Disclosure Document (the “FDD”).  The FDD must contain information in 23 “Items” that are very specific and cannot be misleading in any way.  The Items will disclose such details as:

  • Background information about the franchisor and its affiliates
  • Competition and regulations in the industry
  • Background and work history of the management team
  • Bankruptcy and litigation history of the company and the management team
  • Franchise fees, royalties and other fees
  • Trademarks, patents & copyrights
  • The rights & duties of the franchisees
  • Financial information on the system units (although this is not required)
  • Estimated cost of starting the franchise
  • How/if a territory will be given
  • How a franchisee can have their agreements terminated
  • Dispute resolutions if the franchisee and franchisor have a serious issue
  • The contact information for current and former franchisees

The FDD is a 50 to 60 page document packed full of information that a prospective franchisee can use to understand the offering.  It should be reviewed by an experienced franchise attorney to ensure that nothing is missed and that it is fully understood before making a final determination if the system is a good fit for the new business owner.

Other Factors to Consider

In addition to the legal document review and understanding of the formal relationship between the franchisor and the franchisee, prospective franchisees should take the time to understand the culture, history and interpersonal relationships of the system.  The best way to gain that knowledge is by talking to current and former franchisees of the system.  The contact information for all current franchisees and franchisees who have recently left the system is required to be disclosed in the FDD.

Conclusion

All prospective franchisees should take the time to talk to as many franchisees as possible.  They will be able to tell you what it is like to be a franchisee of the system, how problems are handled and if they had to do it all over again would they still buy into the system. Your franchise attorney, as part of your due diligence on the system, can help you prepare a list of questions and strategies when speaking with franchisees.  Do not skip this step, it is the single most important thing you can do before you buy a franchise.

Generally speaking, franchising remains one of the best ways to get into business in the United States.  It has created billions of dollars in wealth and millions of jobs.  However, it is a big step with big responsibilities and a Franchise Agreement should never be signed until the prospective franchisee understands and appreciates the journey they are about to embark on.