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How to Detect Red Flags in Franchising Opportunities

It can be difficult to identify genuine franchise opportunities with so many people masquerading as the real deal. The lucrativity of franchise businesses can also be a trap to potential investors.

Potential franchisees need to hire a franchise law attorney before investing their hard-earned money in a seemingly mouthwatering franchise opportunity. Franchise attorneys have the right skills to detect any red flags and help you avoid potential losses.

Identifying a Good Franchise Opportunity 

You’ll come across many franchise opportunities both online and offers from random strangers. These deals are typically designed to confuse potential investors. It’s difficult for inexperienced prospects to identify low-risk opportunities with a high probability of success. 

Investors should do comprehensive due diligence, so they must know where and what to look for. Conducting due diligence can also involve identifying potential risks that the business may pose and identifying risk management strategies. 

The due diligence process helps potential investors make informed decisions about the purchase, the price to pay, and the management of the business. Conducting due diligence involves investigating and reviewing or evaluating the following aspects of the franchise business you want to invest in:

Contracts 

This includes existing agreements between the franchise business and staff, suppliers, and all other stakeholders.

Financial Records 

Financial records can include income & expenditure statements, profit and loss statements, cash movement accounts, tax returns, fixed asset movement schedules, and more.

Expenses and Liabilities 

Expenses and Liabilities can include bank loans, utility accounts, lease agreements, and debts like outstanding supplier balances.

Business operations 

This includes intellectual property, trademarks, stock, tools, and equipment, among others.

Identifying the Red Flags

Probably the most critical measure of the success and performance of a franchise is the financial statements, especially the profit and loss statements. Negative balances on a profit and loss statement indicate loss while positive balances indicate profits. 

While businesses sometimes experience losses, thanks to varying reasons, experiencing perpetual losses is a red flag. Consulting current and former franchisees is also an ingenious strategy to conduct due diligence. But how do you identify potential red flags?

In franchising, a red flag is a warning sign that all isn’t well about the franchise deal. Potential investors and franchisors can burn their fingers if they ignore these warning signs. The following are some of the best ways to identify red flags in a franchise opportunity:

The Franchise Disclosure Document 

The franchise disclosure document discloses crucial information about franchise businesses. This document must be reviewed by potential buyers 14 days before signing a contract.

Potential franchisees can identify red flags by reviewing the information contained in the FDD. Compare your expectations with the FDD to make informed decisions.

Business Experience 

Experience is a must-have quality for competent franchisees. Simply put, a potential investor must be experienced in the franchisor’s business. Otherwise, a lack of experience or gaps is a red flag that should prompt a closer review.

Numerous Litigations 

Legal issues are expected in business, meaning franchises can have disputes that result in litigation. However, most businesses, including franchises, have minimal legal issues, including litigations. Franchisees or franchisors with numerous legal issues are risky to work with.

Bankruptcy or Insolvency 

Bankruptcy or insolvency occurs when a person or a business isn’t able to settle their due debts. This situation can also arise if the assets of a business are less than its liabilities. The franchisee must seek to establish 

who sought relief and why and whether the case was genuine and avoidable.

Franchise Fees

A franchise fee is a consideration paid by a franchisee for operating a business using the franchisor’s name, trademark, intellectual property, and more. A fair franchise fee should reflect industry standards. 

Any discrepancies should be satisfactorily explained by the franchisor. While it’s not odd for successful franchises to charge higher fees, a higher-than-usual fee must be explained.

Territorial Boundaries 

Lack of territory protection and boundaries could result in future disputes between a franchisee and the franchisor. In other words, this is a red flag for future franchise disputes and a warning sign for failure.

Financial Performance Representation

Financial performance representation refers to the express or implied depiction of the performance of a franchise. The representation can be oral, written, or visual and should state a specific range of past sales, income, gross profits, or net profits. 

Financial performance representation can be done using charts, tables, or mathematical calculations. The following records can also be used in the evaluation of the financial performance of a franchise.

  • The balance sheet;
  • Trading account;
  • Profit and loss statement;
  • Cash movement schedules;
  • Fixed asset movement schedule, and more.

Some franchises avoid publicizing their financial performance results for security reasons. However, the law requires franchisors to make financial disclosure in the FDD to potential investors.

 The information in this article can be used by potential franchisees to make informed decisions. Consult a franchise attorney for more on this subject.

Jack henry
Jack henry
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