An Ounce of Prevention

Franchised businesses and other business opportunities have become a major portion of the retail business environment in America. Contact us to ask for one of our free checklists of things to consider before purchasing a franchise or business opportunity, and things to do before offering a franchise or business opportunity for sale.

Franchising offers the seller a method of rapidly expanding its distribution network with reduced capital outlay, while offering the buyer a “big brother” with the expertise to train the buyer to setup and operate a particular business without having prior experience.

Franchisors are also proud to point to Department of Commerce reports which show as much as 95% of franchised business succeed as compared to U.S. Small Business Administration reports which indicate that 65% of start-up businesses fail within the first five years of operation.

The International Franchise Association (“IFA”), the franchise industry’s flagship trade organization of franchisors, franchisees and suppliers which is based in Washington, D.C., reports that, in 2000, most analysts estimated franchising companies and their franchisees accounted for $1 trillion in annual U.S. retail sales from 320,000 franchised small businesses in 75 industries. Moreover, franchising is said to account for more than 40 percent of all U.S. retail sales. An additional IFA funded study estimates that franchised businesses provided almost 10 million jobs, over $229 billion in payroll and produced over $624 billion in output during 2001. Such outlets range from gas stations and fast-food to real estate brokers and cleaning services.

For more than a decade, the Federal Trade Commission has required “plain English” disclosures of required information aimed at increasing the ability of prospective franchisees to make more informed buying decisions. In addition, some states’ laws require registration of offering circulars before a franchise many be lawfully sold.

Despite the fact that more information is disseminated to prospective franchisees than ever before, the franchising industry still suffers from a perception of continuing improper sales practices. The U.S. Congress has considered proposed federal franchisee rights and relationship legislation, but not yet enacted any provisions into law. However, the Federal Trade Commission has long standing disclosure requirements aimed at increasing the ability of prospective franchisees to make more informed buying decisions. In response to state and federal legislative pressures, the International Franchise Association has adopted a Code of Ethics which its franchisor members are urged to follow.

What does all of this mean to an entrepreneur interested in purchasing a franchised business? Any grandmother will tell you that an ounce of prevention is worth a pound of cure. The franchise buyer should be aware that no law can replace the need to obtain a careful review of the franchise documents by an attorney knowledgeable in the state and federal laws which pertain to the sale of franchised businesses and the franchise relationship. The buyer should also properly investigate the franchised business before the purchase takes place. Talking with current and past franchisees is a great way to get a feel for what operating the particular business is really like.

Finally, consult a qualified business advisor who can properly evaluate the opportunity apart from its “sizzle”, and look only at its financial merits. Particular attention should be given to the related issues of sales seasonality, cash flow and adequate capitalization. Business advisors generally agree that most small businesses fail due to their being undercapitalized. This occurs when business owners fail to invest sufficient cash in the business when it is formed, and later do not have sufficient cash reserves or are unwilling to invest further in the business. During periods of seasonally lowered sales, which are common in most businesses, the undercapitalized business does not have sufficient capital with which to ride-out the reduced cash flow. The result is an inability to timely pay the business’ expenses. If the business has questionable viability in these or other areas, a more studied approach should be undertaken.