By Sarah Needleman
August 25, 2014
Martin Pollack, Two Men and a Truck | “Had we not done the due diligence we did, I would’ve lost my entire life savings.” Daniel Conlin
Franchising has never been a more popular option—or, perhaps, a bigger risk.
Over the past few years, people have been flocking to franchising, seeing it as a simpler path to entrepreneurship in troubled economic times. But over that same period, numerous pitfalls have appeared that make franchising much tougher to navigate, say many franchise attorneys and advocacy groups. For one, they say, it’s gotten much more complicated for buyers to get an accurate picture of a franchise before taking the plunge. And, they add, if people do buy into a chain, they may have less leverage over things like how they can pursue complaints against the franchise.
Getting the Background
Of course, vetting a franchise has always been a challenge. Franchisers are not legally required to share key financial metrics with prospective buyers, such as franchisees’ first-year average sales and failure rates. Further, there’s no central regulator that checks franchise disclosure documents.
But these days, many franchise systems are just a few years old and have limited track records for prospective buyers to assess. An estimated 3,581 franchise systems are now operating in the U.S.—43% more than a decade ago, according to research firm FRANdata.
And disclosure documents have gotten more complicated, says Dale E. Cantone, chief of the Securities Division of the Office of the Attorney General of Maryland. For example, today many chains commonly offer a range of unit types for sale, from storefronts and kiosks to mobile units like trucks and carts, as well as the option to become an area developer or area representative. A lot of people “are intimidated by the disclosure document and find it difficult to go through it with the degree of due diligence they should,” he says.
At the same time, some franchisee advocates say more chains are giving potential owners misleading information to get them to buy into the system.
The recent recession and subsequent slow recovery have prompted franchisers in recent years “to be more aggressive on their claims to success,” says Keith Miller, chairman of the Coalition of Franchisee Associations, a trade group representing more than 35,000 franchisees nationwide. “They’ve been stretching the truth on revenue and profitability because people have had less money to invest in franchising.”
There’s no official count of complaints, but many franchisees and others knowledgeable about the industry report hearing them lately. Miami law firm Zarco Einhorn Salkowski & Brito PA has taken on 15% more cases over the past two years involving franchisees seeking legal retribution from franchisers, says senior founding partner Robert Zarco. He says claims of franchisers misrepresenting themselves in sales pitches and disclosure documents are among the most common complaints.
Critics also warn that people who do buy into franchises may have to sign tougher agreements with more restrictive terms than in the past. Franchisers have long been “tightening the screws on their franchise agreements,” says Bob Purvin, CEO of the American Association of Franchisees and Dealers, a trade group with 6,000 franchisee members. For example, he says, more franchisers are requiring franchisees to buy supplies from specific vendors.
While that’s not necessarily bad in itself, he says, many franchisers are getting rebates in exchange for the arrangements and not disclosing or sharing them. “The number of complaints over the abuse of the supply chain has soared dramatically in the past few years,” Mr. Purvin says.
Also, many franchise agreements now include clauses that prevent franchisees from taking franchisers to court if they believe the franchiser breached their contract or committed fraud, says Justin M. Klein, a franchise lawyer in Red Bank, N.J. “In many situations, franchisees can only go to arbitration,” he says, adding that arbitration decisions are typically nonappealable.
It’s also more common for franchise agreements to prohibit class-action lawsuits and class-action arbitrations, as well as to include shorter statutes of limitations for taking legal action against chains, says W. Michael Garner, a franchise attorney in Minneapolis.
The International Franchise Association, a trade group with about 14,000 franchisee and 1,350 franchiser members world-wide, acknowledges that there are risks associated with investing in a franchise and that buyers need to do due diligence when considering a franchise opportunity of any kind.
But it says accounts of franchiser misbehavior and forcing restrictive agreements on owners are anecdotal—not evidence of a widespread trend. What’s more, the group says, the growth in options for prospective buyers is a sign of the industry’s vitality.
The group’s president, Steve Caldeira, disputes that risks have increased in recent years, and cites as evidence that the industry has been growing in terms of units, employment and revenue. Franchising “is a proven and time-tested business model,” he says.
The best course, franchise experts say, is for buyers to do extensive research on a franchise’s industry and competition, talking to multiple franchisees and using public databases like Pacer.gov to look up lawsuits and bankruptcy filings. In addition, they recommend studying franchisers’ profiles on sites like Facebook and Yelp to see how they interact with consumers, as well as looking up top executives on LinkedIn and similar sites to learn about their experience. Independent franchisee associations can also provide information.
For an idea of what that can involve, consider the story of Martin Pollack and Adam Slack of Alexandria, Va., who set out to buy a franchise last year. It took countless phone calls, emails, meetings and online research to dig up information that wasn’t disclosed, such as why past franchisees had shut their doors. Many franchisees they spoke with claimed that franchisers’ sales materials were misleading and their units were struggling to survive as a result.
After almost a year of searching, Messrs. Pollack and Slack settled on a moving franchise called Two Men and a Truck. They invested roughly $300,000 to open a location in Alexandria, Va. They’re planning to open two outlets in the Washington, D.C., area by January and are on track to post more than $1.5 million in sales for 2014.
Looking back, Mr. Pollack says the time and energy the duo spent on selecting a franchise system was well spent. “Had we not done the due diligence we did, I would’ve lost my entire life savings,” says Mr. Pollack.
Ms. Needleman is The Wall Street Journal’s small-business assistant editor. She can be reached at firstname.lastname@example.org.