Avoiding Fraud When Buying a Franchise Business

Do You Think You Do Not Need Due Diligence When Buying a Franchise?

Opening up a new franchise location can cost upwards of $250,000. This is a lot of money for a business buyer to invest in a new unproven location.

New investigative reports are now stating that the selling of new franchise locations is where the real profit is earned by franchisors, rather then as previously believed on the 5% franchise fee paid  from the sale of product. The franchise sales staff  earn a large chunk of the $30,000 plus franchise fee charged. Plus the company makes a profit on the construction costs of the new store.

Many people have the idea that our government’s registration rules exist to protects the consumer from being cheated. In truth it has made the problem worse.

Under the old rules the franchise would give you financial information about their best store, in order to entice you to buy their franchise license. Under the current rules they can not give you any financial statements to impress you that their franchise will make you a lot of money. Therefore all their selling is based on what is called in the used car business as “fluff”.  My dictionary defines “fluff” as ‘any light or trivial matter or talk’. It is non-specific and legal.

If 1 is Making Money it Doesn’t Mean 2 Will.

One of my friends owned a smoothie drink franchise location where sales were increasing nicely. So he bought two more smoothie drink franchises. He thought he was making a profit. He never called me to ask my opinion, before buying any of the locations, which proved to be a mistake, and he borrowed $500,000 on his free and clear real estate to pay for them.

So, when that wild spending in the economy stopped, he called me up to sell two of them. To my surprise, the rent on all three locations was too high for him to make a proper profit. The first location was just starting to make a profit when he purchased the other two. The third location rent was so high he would have had to do $75,000 per month in sales to make a reasonable return on his money. There are few if any stores in this chain that do that volume. He was dead before he opened up. He bought the stores because of the salesman was giving him a lot of hype and fluff.

What you need to know before buying a franchise business.

How do you protect yourself from Franchise Fraud? I have three recommendations:

1. Make sure the rent is not over 15% of the estimated gross sales for the location they want to sell you. To know that, of course you’ll have to work out an estimate as to what you believe your estimated gross sales will be. Do not be too optimistic in this process.
2. Talk first hand to at least three franchise owners in your community. Do not let the franchise company recommend which owners to call. That is illegal by the way. You need to, yourself, look up the franchise on the internet and find some local franchisees. Talk to them and find out what their actual gross sales are as well as any other questions you may have.
3. Get an expert to review the franchise proposal. Locate a CPA or other business due diligence expert who has a lot of experience with franchise businesses and pay that expert to help you review the franchise proposal. A few hundred dollars now can save you half a million in cash and five million in grief.

The differences between a profitable franchise and a money pit are not always easy to discern, which is why it pays to put in the due diligence and also consult an expert.

Franchise business due diligence is a must, as you can see. If you disagree, call me, and I’ll walk you through it. Or read some of the horror stories I’ve posted on my site. I’ll be glad to clear it up for you.   If you have had a similar experience please feel free to let me know I would be interested in hearing from you.

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Image credit: IvanMikhaylov  iStock