Is It Time to Buy a Franchise?

When the economy slumps, franchising tends to become more popular. Here's what to know about the industry before buying in

by John Tozzi

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Think buying a franchise means you get the benefits of owning a business without the risk of business failure? Think again. Without proper due diligence, franchisees can find themselves stuck in bad business models, chained to unfavorable contracts, or victims of fraud. Although the industry's reputation has improved in recent years (BusinessWeek.com, 4/12/05), franchising isn't necessarily safer than starting a new business.

Economic slumps tend to boost the industry, as unemployed workers seek to start businesses with the perceived safety of established systems. The International Franchise Assn., the industry's largest trade group, estimates there are about 3,000 franchise systems in the U.S. today. The concepts range well beyond fast food, with franchises in industries as diverse as pet care and tutoring services. In 2005, franchised businesses employed 11 million people— more than 8% of private sector workers—and generated 4.4% of U.S. economic output, according to a report by PricewaterhouseCoopers commissioned by the IFA. John Reynolds, president of the IFA's research arm, expected growth in franchising output and employment to continue at least through the middle of 2007.

Think Like an Investor

Where should you start if you're new to franchising? Aspiring franchisees need to think more like investors than entrepreneurs to thoroughly vet any opportunity before buying, franchise experts say. "The franchising industry represents that franchising is a safe and secure path to business ownership," says Robert Purvin Jr., head of trade group American Association of Franchisees & Dealers and the author of Franchise Fraud: How to Protect Yourself Before and After You Invest. "But in today's marketplace, franchising is almost never business ownership, and it is very often not a safe and secure path." He explains that buying a franchise means buying a license to operate someone else's business for the period of the contract.

Purvin says prospective franchisees should first check whether a system has an independent franchisee association (BusinessWeek.com, 1/29/07) that the company recognizes. These organizations let franchisees share information, negotiating power, and legal resources. If a franchisor doesn't recognize an independent association, Purvin says buyers should keep looking. "I would limit my search to companies that have an established collaborative culture so that I know if problems come up there's going to be a process in which we can air those problems and resolve them," he says.

Although state governments and the Federal Trade Commission (the FTC offers a guide) require franchisors to disclose information about their offerings, franchisors do not have to register with any federal agency the way publicly traded companies must with the Securities and Exchange Commission. You can get disclosure documents from franchisors after you express interest and get initial approval. You can also buy them from companies like FRANdata. The disclosures, known as Uniform Franchise Offering Circulars or Uniform Franchise Disclosure Documents, require franchisors to reveal information on 23 items, from numbers of lawsuits and bankruptcies to fees and other estimated costs. (Note that the FTC introduced an amended document in January, 2007, called a Franchise Disclosure Document that will replace both the UFOC and the FTC's original disclosure document and become mandatory on July 1, 2008.)

Disclosure documents also must contain information on other franchisees, including those who have left the system.