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Posted on Jun 29, 2011

Watch out, Franchisees! 10 Franchisor Red Flags

Red Flag - Franchise HelpAllow me to preface this article by saying that this list is not meant to be definitive nor absolute. I am aware of many legitimate and trustworthy franchisors whose systems meet at least one of the criteria listed below. Like any enterprise, it is reasonable for franchise opportunities to have their faults. However, in general, if a franchisor that meets more than one of the criteria listed below it may be a sign of systemic degradation or illegitimacy. Potential franchisees should think carefully, ask lots of questions and seek professional guidance before committing to a franchise system that raises too many of these red flags.

1. Sloppy or Incomplete Franchise Disclosure Document

If the franchisor has sloppy or grossly deficient franchise forms (such as the FDD), this can say a couple of things. A sloppy or incomplete FDD typically signals either (i) that the franchisor does not have a lawyer, and it prepared the FDD either on its own or using online software, or (ii) that the franchisor does perhaps have a lawyer, but the franchisor did not take the time to review the FDD. Either way, this suggests a lack of investment (both financial and personal) in the franchise system.

2. No State Registrations Identified in the FDD

Only a limited number of states require registration by franchisors, and franchisors are by no means required to register in states where they have no intention of selling franchises. However, if a mature franchisor appears to be consciously avoiding the registration states, this may suggest some level of internal concern about the FDD, the franchisor’s sales tactics, or the franchise system as a whole. The cover pages of the FDD will identify where the franchisor is required to register (and whether it has registered or not), and the charts in Item 20 of the FDD will explain whether the franchisor has ever sold a franchise in any of the registration states.

3. Small Number of Franchisees After Years of Operation

This red flag obviously does not apply to new franchisors. However, if a mature franchise concept has zero or only a few franchisees despite years on the market, this may suggest either (i) a lack of dedication to the franchise system, or (ii) fundamental issues that prevent potential franchisees from moving forward with the opportunity.

4. Inability to Answer Basic Questions About the System

Another significant red flag when evaluating a franchisor is its owners’ and sales representatives’ abilities to answer basic questions about the franchise system. They don’t need to have memorized every single provision of the franchise agreement, but they should be able to speak knowledgably about the core provisions of the franchise agreement, and they certainly should be able to answer your questions about operating standards and procedures, supplier relationships, and other basic components of the franchise program.

5. Focused More on Franchise Sales than on Franchisee Success and Satisfaction

As a potential franchisee, the franchisor’s salespeople and “corporate” representatives should show a sincere interest in trying to make sure you are a good fit for the system, and they should demonstrate a commitment to maintaining franchisee satisfaction on an ongoing basis. If these people are  more focused on closing the sale than making sure you are a good fit for the system or addressing the concerns of their existing franchisees, this may be a sign of things to come after you sign the franchise agreement.

6. Lots of Franchisee-Related Litigation

If the FDD discloses a significant number of franchisee-related lawsuits in Item 3, this too may be a sign of things to come. Whether these are lawsuits by franchisees against the franchisor or lawsuits by the franchisor against franchisees for unpaid royalties, this typically is not something you want to see when considering entering into a long-term binding franchise agreement.

7. Administrative Enforcement Actions

Some states have administrative enforcement agencies that take action against franchisors to protect the interests of prospective franchisees and consumers generally. Some states, such as Maryland, post listings of their administrative enforcement actions online. Depending on the nature of the enforcement action, this can be a significant red flag that can have both operational and financial consequences for the franchisor.

8. No Prior Experience in the Industry

Occasionally, a franchisor will have no prior experience in the industry in which it is offering franchises. When this is the case, you need to question why the franchisor believes it can help you succeed more so than if you went into business independently on your own.

9. Limited Capital Infusion or Equity

Again, this is not necessarily a red flag, as many franchisors start small and thus can justify a relatively modest capital investment in the franchise system. However, if a franchisor’s financial statements show a limited capital investment or minimal equity (or substantial debt), potential franchisees should question whether the franchisor is both (i) committed to the franchise system, and (ii) able to meet its obligations and develop and expand the franchise system on an ongoing basis.

10. Public Complaints

Finally, as with almost anything these days, the web is a valuable and somewhat-trustworthy resource for information on unscrupulous and problem franchisors. If searches for the franchisor return voluminous complaints by franchisees or former potential franchisees, this likely is an important red flag that should be investigated before committing to the franchise system.

Jeff Fabian is the owner of Fabian, LLC, a boutique intellectual property and business law firm serving new and established franchisors and franchisees. Visit www.thefranchisecafe.com or www.fabianlegal.com for more information, or contact the firm directly at 410.908.0883 or jeff@fabianlegal.com. You can also follow Jeff on Twitter @jsfabian.

This article is provided for informational purposes only, and does not constitute legal advice. Always consult an attorney before taking any action that may affect your legal rights or liabilities.

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