If you are looking to transition from employment to business ownership, choosing a franchise is definitely one of the safest, smartest ways to do it. However, it can be confusing, especially understanding some of the jargon.
I was recently asked by someone who was quite advanced in looking at franchise opportunities; “what does the term due diligence actually mean?” They had heard franchisors talk about it and read articles that mentioned it. They thought they had a rough idea, but actually didn’t fully understand at all what it meant for them personally.
If you Google “What does the term due diligence mean?” You will find some pretty dry explanations which may still be unclear and full of jargon to someone who is new to business ownership. In this article, I aim to demystify and easily explain what the term “due diligence” means, so that it can be easily understood by anyone who may be looking to invest in a franchise for the first time.
Due Diligence Is A Process
In simple terms. Before purchasing a franchise, “due diligence” means that you have taken time, care and effort to fully understand the business you will be investing in. What the full costs and legal implications are, what the franchisor will provide for you and what is required from you.
Making sure that you are thorough when finding out this information, BEFORE you sign on the dotted line, will reduce the risk of any unpleasant surprises once you have purchased the business. Without it, your dream of being your own boss and having your own franchise can very quickly turn into a nightmare.
What Exactly Does Due Diligence Mean When Evaluating A Franchise?
There a number of important things to consider if you want to become a franchisee and some essential steps to follow in the due diligence process. I have had someone say to me “this is boring and time consuming”. Well, yes, it is to a certain extent, but it is crucial to do it thoroughly. Otherwise you will potentially leave yourself open to huge risks.
Look at it another way. All you are doing is simply giving yourself the best opportunity to gather all of the important information that you need. Then you can make a fully informed decision, before purchasing a franchise business opportunity. Minimising any problems or losses that you could have avoided, if you had been more thorough before signing on the dotted line.
How Do I Carry Out Meaningful Due Diligence?
Before entering into a franchise relationship, you need to know what you are getting into. Thoroughly investigating the proposed franchise opportunity, will help you to be in a better position to decide whether to invest or not.
When selecting a franchise, look for a business sector that genuinely interests you. Define how much you can afford before you choose. You might investigate several franchises before you find the one that seems right for you. That’s fine, it is all part of the process. The important thing is not to rush into it. Take your time, find out as much as you can about the business, how it works, why it works and what it will take to make it work for you.
Remember: You need enough money to buy the franchise, run the business until you can take a wage from it and support yourself in the meantime.
How much effort you put into this process will have a direct effect on whether your business succeeds or fails. So, do not underestimate the importance of carrying out a thorough investigation before giving the go ahead. Find out all you can about the business, this will help you to avoid some of the basic due diligence franchising mistakes (see BOX1).
When you understand the real information about the franchise opportunity, you will be in a better position to compare competing brands. You may also reach a point where you feel comfortable to commit to a long-term relationship with a Franchisor.
Where Can I Find The Information For Due Diligence?
Online: These days most people conduct their first look at franchise businesses on line. Often you can find out a lot about a franchisor before you even contact them. Look out for franchise industry publications & websites. You may also find Franchisee forums, social media forums such as Facebook pages etc. These can all be valuable sources of information.
Brokers & Professional bodies: Something that is growing in the UK is the use of Franchise Brokers that can help to guide and mentor you through the process. The British Franchise Association (bfa), and independent trade associations may also be able to help you find information on the franchise opportunity that interests you.
The Franchisor: Obviously, the franchisor is an excellent source of information. A good franchisor should be able to clearly explain the business proposition and provide answers for most, if not all of your questions. What you can expect your annual turnover to be in year one, year two and onwards. What investment is required to get started. They can even provide funding options and point you towards reliable legal advisors. (see BOX 2, BOX3 and BOX4).
Some franchisors explanation of what you can earn, are more accurate and reliable than others. You should always verify what you are told, with your own independent research and financial calculations. Franchisees are an excellent source for this.
However, if a franchisor cannot answer basic questions about their business, or if it attempts to hide or offer misleading information, it may indicate that they do not have much of a business system at all. This should be an early warning sign and flag up as an alarm.
You can download questions to ask franchisors from the British Franchise Association website www.thebfa.org or from franchising banks such as HSBC, NatWest and Lloyds Bank.
Existing Franchisees: A very, very important part of due diligence is to speak with as many franchisees as you can. Understand that this is a managed process by the franchisor. They want to put their best franchisees forward, so that you get a good impression of the brand and business opportunity. However, you can learn a lot from franchisees that are underperforming too. What are they doing that is different? Or is the business only viable in certain parts of the country such as inner city areas etc?
Franchisees will normally speak freely and honestly about what it’s really like to be part of the brand and exactly what the business involves. They will generally tell you what they earn (unless they think you are a competitor). They will tell you how long it took them to break even; the real costs involved; what you really get for your franchise fees; the biggest challenges they faced etc.
They will be able to explain what the relationship with the franchisor is really like. How effective was the training and launch of the business? Is the support from the franchisor genuinely as good as they claim it to be? What are the benefits and burdens of the business. Are the earning potentials real and achievable? What things to avoid and to look out for. Most of all would they do it again, knowing what they know now.
Will I Cover Every Eventuality?
Although it is impossible to turn over every stone when conducting your due diligence investigation, you can use the information boxes provided as excellent guides. They will assist you in finding out what you need to know, so that you can close the gap and make the leap of faith less daunting.
If you are still dreaming of running your own business by means of a franchise, now you know what due diligence is and what it involves.
If you follow this process you should be able to avoid the common mistakes that people make. You can use the information to compare competing opportunities, take the emotion out of your decision making and be confident that your decision is based on facts.
BOX 1: Due Diligence – Common Mistakes
Not having sufficient funds to buy, operate and run the business until such
time you can draw a wage from it;
Making an emotional, hasty, uninformed decision;
The business is not a good fit for you and your aspirations;
The business isn’t what you thought it was;
Not spending enough time speaking with the franchisor;
Not speaking with enough franchisees;
BOX 2 – Due Diligence – The Franchisor
What is the size of the business opportunity?
How long has the business been established?
How many franchisees do they have?
What is the churn rate of franchisees?
How many franchisees do not complete the full term of the franchise?
Have there been any franchise failures? What was the reason?
How has the Franchise business system developed over the years?
How strong is the brand?
How experienced are the franchisor’s directors & employees?
What support will you receive?
What does the training, launch and ongoing support consist of?
What makes the franchise system stand out from any competition?
BOX 3 Due Diligence – Financial Considerations
What is included with the Franchise Fee?
What are ongoing Management Services Fees or royalties?
How much working capital will I need to run the business?
Are there any additional marketing or advertising fees?
Any other ongoing or extraordinary fees such as IT Fees?
When can I reasonably expect to break even?
What can I expect to earn after fees, taxes etc?
Can I grow the business?
Do I need staff or premises? If so what will they cost? What will I be left with?
Do I have enough money to buy the business, operate the business until I can take a wage, and live while I get the business off the ground?
BOX 4 Due Diligence – Legal Considerations
What is the length or term of the franchise agreement?
What are the renewal terms? Are there any costs involved?
What are my obligations to the franchisor?
What are the Franchisors obligations to me?
Do I have any rights to transfer the business at a later date?
What are my termination rights?
What happens if I terminate the agreement before the end of the term?
What are the franchisors termination rights?
Are there any mandatory purchases from the franchisor?
What happens if there should be a dispute?
How is the territory defined?
Always take legal advice from a franchise lawyer before signing any agreement.
This post was written by Matt O’Neil, Founding Partner of Franchise Matchmaking Services