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Overview | Why You Need Help | Economic Due Diligence | Due Diligence on the Contract and Disclosure Documents | Walking Around, Tire Kicking Due Diligence | The Ultimate Due Diligence
Your company has been acquired or is downsizing or for other reasons you are out
of a position. What are you going to do now? The usual route is to look for
another job, but there are lines at all those doors and you aren’t getting any
younger. You have access to around $ 500,000 in cash and liquidity if you know
how to evaluate your financial position (including what you have that is
refinanceable, plus your exit compensation), and you can go into your own
business. But you have never done that before. You are scared to death if you
have any sense. If you don’t know how to select a deal due diligence – not just
the legal documents – franchise lawyer, you’re on your own. You need a map, a
guide to get it done.
Here it is.
Every day there are thousands of businesses or business opportunities for
sale. Any attempt to list them would be wasted effort. There are so many, in so
many different locales, of varying descriptions, sizes and conditions of health.
The list changes hourly. We are now at the point at which the processes by which
you have screened attitudes, aptitudes, capabilities and aspirations have
narrowed the scope of your search. We assume you have preferences, possibly a
willingness to relocate, and a reasonable appraisal of what you might be able to
handle regarding the size of required investment. You must define investment to
include all costs through closing of the purchase; the cost of operating the
business to break even and living expenses for at least two years in case it
takes that long before you can start taking money out. In a new start up
business, you must – yes must – regardless of what you are told by anyone else –
plan not to hit break even or positive cash flow that is not already consumed by
debt service for AT LEAST TWO YEARS.
Your choice will be either a brand new start up business, possibly a franchise
in which you are purchasing the right to use somebody’s already developed system
and name; an up and operating franchised business which is available for resale;
or an up and operating independent small business, not part of any chain system.
If you are looking at an already up and operating business, you will be expected
to assume leases, buy the site, inventory, equipment and fixtures, plus a
premium called “good will”, the value of the fact that the initial start up
risks have already been taken by someone else and you are getting a business
that makes money. Never buy any business that does not make verifiable profit,
no matter what reason is given for its ill health. The reasons given will always
be false. “Going concern” value must be proved if you are paying for that value.
Only complete three to five years of federal tax returns will tell you reliably
what that is. No one ever overstates his profitability on his tax returns.
In a new franchised start up you will be expected to pay for site development,
including buying or leasing existing property that may or may not already be
built out to some degree of completeness and suitability, modifying an existing
facility to accommodate the layout requirements of your new business format,
equipping the business and establishing support services such as insurance,
telephone, utilities and other purchased functional support. You will be told
that you are in business for yourself but not by yourself. You will be in
business for yourself AND by yourself.
In any event, by this time you will also know what your money requirements
should be, including what you have and what you can borrow. If you are going
into this with partners, all partners must have done this exercise. The benefits
and very real risks of partnering are not a part of this discussion. If you
don’t have to have partners, by all means don’t go that route.
Now you are at the point at which something called due diligence comes into play
as the essential skill that should reduce failure risk in the business you want
to buy. Some risks are obvious. You buy insurance to replace destroyed assets.
But anything you buy may have latent defects, nothing you can readily spot from
what you are being told by the people who are trying to sell you the business,
but fully capable of wiping you out. Think about inaccurate information that
seems perfectly plausible given to you by professionals at spotting what you
believe you really want and then telling you that they have just the right
thing.
Statements, representations, financial information of any kind all have to be
verified. In a going concern acquisition you can see tax returns and bank
records. But in a start up you have to have expertise working for you, someone
who knows how to identify the risks inherent in unknowns. No one trying to sell
you a franchise or other kind of business is going to tell you where the bodies
are buried.
You have various personal useful traits, an education and some degree of
business experience, possibly in a company, in management, production or sales,
and maybe in several companies and in more than one industry. In a corporate
environment you had access to support functions provided by the company for
which you didn’t have to pay, like accounting, insurance, law department,
advertising and so on. What you needed from these other disciplines you simply
picked up the phone and arranged for. In a small business these support
functions are not there without cost to you. You have to find them and pay for
them.
A franchisor will tell you that’s what you get when you buy a franchise, but in
most key areas of needed support that simply is not so. When your plumbing,
electricity and equipment fail you have to get them fixed yourself. There is no
maintenance department. You are the maintenance department. The franchisor will
not fix anything that breaks, or defend you in lawsuits, or absorb your
uncollectable receivables, resolve any of your labor or environmental pollution,
public health or safety problems, nor will he protect you on the way to the
bank. You buy your own insurance, deal with your own claims adjustors; pay your
own bills, run your own adverts and so on. You also do not get to offset from
your royalty obligations sales you made on credit and failed to get paid for.
You pay on gross, not net.
In this find a business to buy project you are on your own, and no matter what
you did before, you don’t have the skills to do the due diligence for this
project. Even if you were in corporate mergers and acquisitions you were not
buying one small single store start up, but a significant going business with
verifiable information, often certified. You will get no certified financials on
any franchised business you but. The franchisor may have its financials
certified, but that tells you very little because you don’t know how to evaluate
franchise accounting or analyze franchise financial statements. Because people
who buy small businesses lack sophistication, sellers make outrageous
representations and try to hide documents that might reveal critical negative
truths. Some will ask you to pay “good faith” money to see documentation –
outrageous. Others will show you unverifiable incomplete data and tell you
that’s all you need to see in order to know what you want to know.
You won’t know, for example, how many times the business has already been sold
and taken back for failure to make payments. Find the answer to that issue. You
probably think this is insane. It isn’t. It is actually rather ordinary. People
have no qualms about asking hundreds of thousands of dollars for businesses that
never made a profit. Suckers buy these because they believe it when told that
all it needs is the right operator with imagination who is willing to work hard,
or that there is more cash in the business than its records show or that the IRS
knows about. Suckers believe this nonsense.
You will need an accountant and a lawyer. They need to be introduced to each
other and told it’s OK for them to talk about things that ought to be talked
about. This is no time to be penny wise and pound foolish. If you are buying a
franchise, select a lawyer who knows the franchise business and who does due
diligence on BOTH the contract and disclosure documents AND on the deal itself.
All franchise contracts say about the same thing when you get right down to it.
It is the deal quality or lack of quality that will kill you. If you don’t want
to hire me, go on any search engine and do a search on the words Franchise
Attorney. Call the lawyers who come up on the first page of the search results.
Ask them two questions. Do you regularly do pre investment due diligence on
franchise investments as part of your law practice? You must get a yes answer to
this question or the lawyer is of no use to you. The second question is, Do you
vet the deal as well as the legal documents? You also must get a yes answer to
this question. Many business lawyers won’t vet the deal because it is not legal
advice and they would not be covered by their malpractice policies. Forget them.
They are of no use to you. Only hire a lawyer who answers Yes to both those
questions.
If you hire someone who does not do this regularly, do yourself a favor and have
the lawyer read the Franchise Fraud Symposium articles on this web site. It
won’t make him an expert, but it might kick up the quality of the work you hire
him to do. Just understanding franchise accounting statements is a different
discipline. What, for instance, are the implications of a franchisor’s having
very little past due receivables if it has a substantial notes receivables
amount on its balance sheet?
If you are buying an already operating business that is not a franchise, ask
your accountant and lawyer if they regularly represent people who are buying an
existing small business regarding doing the due diligence on the investment.
Hire only those who answer Yes.
Economic due diligence includes initially vetting the information in Items V,
VI and VII of your franchisor’s FDD (Franchise Disclosure Document – formerly
called the UFOC). These deal with fees – initial franchise fee, royalties,
advertising fund periodic payments, and so called “other fees” (at the end of
which it should say that there are no other fees), and the estimated total
initial investment.
Ideally, you will be looking at the FDDs of more than just the one franchisor
you are immediately interested in. In this exercise you are comparison shopping.
You are attempting to measure the metrics of competing franchise offerings. In
this comparison shopping you compare every item in the FDDs against each other,
including historical information, length of time in business, number of
franchisees, terminations, reacquisitions, historical franchisee counts, length
of franchise term, renewals – every provision compared against each other
amongst several franchisors in the same business.
You will do external research, looking up industry associations relevant to the
business that you are interested in. Most businesses have trade associations,
and trade associations keep track of the vital statistics of the business
segment as well as other extremely valuable information. For one thing, for
example, they account for independent, non-franchised businesses within the
industry and often offer their own training and business method programs that
may be good enough to avoid having to be a franchisee if you are really
interested in this particular kind of business. You cannot afford to fail to
consider how to get into the business without having to incur the costs of
carrying the franchise expenses every month.
Many franchise companies still claim that your survival chances are better as a
franchisee than as an independent. That has always been a false claim and it
remains a false claim. All the respectable research shows no difference
whatsoever in mortality depending upon whether one is a franchisee or an
independent.
In Item VII the amount of working capital needed is always seriously
understated. Working capital is the amount of money you will need to pay the
bills and to live on until the business achieves profitability or at lease
sufficient free positive cash flow (that you don’t have to use to repay loans).
In Item VII you are looking at roughly 90 days of estimated working capital with
no allowance for living expenses. You will not hit break even in 90 days, and
you will absolutely not be making any money to handle living expenses in 90
days. You must figure that you will have to operate the business for at least
two years in order to begin making any money. That difference in the picture you
have to plan for in your business plan frequently accounts for why new
businesses fail. It is called gambler’s ruin in economics. Even if the business
does eventually have favorable prospects, if you don’t have sufficient working
capital to finance your way to profitability you will never get there. You
absolutely must do the math to determine how much money you have to have to pay
the bills and live on for two years. You will be amazed at what the total
initial investment looks like when you perform that exercise. If you don’t do
it, you can pretty much count on ending up in bankruptcy court. If the business
ends up performing better than that – unlikely – then your surprise is a
pleasant one.
One of the exercises you will be told to perform is the interview of numerous
franchisees to inquire regarding their experiences as buyers of this franchise.
You must do that. You must include the question “If you were making this
investment all over again, knowing what you know now, would you do it?”
While you must interview franchisees, you should also try to interview every
former or present franchisee identified in Item III having to do with disputes.
Those will be the people who not only did not do well, but who also believe that
their difficulties were caused by the franchisor.
Be aware that franchisees you interview will be apprehensive about speaking to
you, no matter how they may seem to you during the conversation. The reasons
they may not tell you about the problems include that they believe you may not
be genuine – that you may be someone working for the franchisor trying to find
out who is badmouthing the business for purposes of retaliation. They may tell
it better than it is for fear of impairing their ability to resell their
business and get out of the franchise relationship. They may simply resent the
conversation as an intrusion on their privacy. Franchisee interviews are not as
important a part of due diligence as they historically have been thought to be.
You must find out what these franchises are really doing. The best way to do
that is to present yourself as a potential investor in a resale. You will sign a
confidentiality agreement to get financial information on an existing business,
but you never pay money – no matter what it is called – to get financial
information. You also do not provide your own financial information. You tell
the seller’s agent that you will provide your own financial information if and
when you make an offer to buy. Get at least three years federal and state tax
returns, and preferably five years. Any reluctance to provide financial
information at that level of quality means that you are looking at a bad
business and you wouldn’t buy it as a going concern or as a start up.
If there is an independent franchisee association of these franchisees, that is
a good place to ask questions. However, there is a substantial difference
between an independent franchisee association and a franchise advisory council.
The FAC is a farce, a group hand selected by the franchisor because they are
weak and will cheer lead for anything the franchisor wants them to support.
Their reasons for doing this do not apply to you. You must consider yourself as
a potential member of an independent franchisee association, not a franchisee
advisory council.
If there is not an independent franchisee association in the franchise you are
considering, that is a very negative sign. It means that the franchisees will
not support each other in dealing with problems and in trying to provide
organized resistance to the many opportunities provided for in the franchise
agreement for an opportunistic franchisor to rip off the franchisees with
charges they never envisioned; forcing them to buy things they never
anticipated; reconfiguring the franchised business at substantial cost without
competent evaluation of whether the reconfiguration expense has a shot at
improving financial performance of the franchise business; and many other
abuses.
If there is an independent franchisee association, ask about problems they have
encountered and how they went about addressing them. Ask especially about what
results they achieved in each of these problematic instances. Some independent
franchisee associations are more social clubs than effective vehicles to protect
franchisee investments and revenue expectations. You have to find out who you
are dealing with.
The
FDD, so they say – but it isn’t true – is supposed to ex[plain to you what the
contract terms mean. You can’t rely on your study of the FDD to obtain a
competent appreciation of the significance of the contract terms. For one thing,
some of the terms are enforceable, not enforceable, only partially enforceable
depending upon what state the franchisee is located. Take the covenant not to
compete after expiration or termination of the franchise agreement. You have to
read the state specific page for your state as you are reading the contract in
order to find out what the impact of your state law may be on various contract
terms, especially this one. The same is true for dispute resolution provisions.
Many franchise contracts now have “liquidated damages” provisions that provide
for your automatic liability if you go out of business, regardless of the reason
for your doing so. You probably never recognized that until you just read it
here. Franchisors attempt to engineer the language to conceal the impact of
these provisions. You have no idea how they go about doing that, so you can’t
possibly sort it out by yourself.
Every contract provision is an economic statement that describes how your
investment can be enlarged far beyond what you think you are investing in this
business relationship. For an explanation of how this works see http://www.franchiseremedies.com/franchise-investments-legal-business-issues.htm
. You probably never imagined this either until just now.
You think you have renewal rights, but that is an illusion. When this franchise
contract term runs out you only have the rights that a new franchisee applicant
has. You have to sign a franchise contract that your franchisor is then offering
to newbies, and you have to sign a general release of all claims, known and
unknown in order to get approval to “renew”. Renewal of the agreement you signed
is not your right. That means that the capital value of your business is reduced
by the impact of the new agreement upon the bottom line of the business. The
terms are never better than they were. You will lose capital value when you
renew because the new agreement closes loopholes that may have arisen since you
first signed on and often reduces territories, eliminates territorial rights and
increases fees.
The same dynamic occurs when you sell your business. Your buyer has to sign the
new franchise agreement then being offered in almost every instance, and you
have to sign the same general release to get approval to sell. The impact of the
terms of the new agreement will reduce the value of what you have to sell.
Illustratively, in a one million dollar gross sale business that produces 15 %
net profit and carries a 5 % royalty, the franchisor is getting one third of
your bottom line just for the royalty payment alone. If in the new agreement the
royalty goes to 7 %, the royalty alone is almost half of the net profit. Your
capital value decreases substantially and your resale price will reflect that
the value to the buyer is less than the value to you. If you are the buyer, you
can’t afford to figure your purchase price on historical financial performance
of the business because in your hands it won’t be producing that much profit
even under the best of circumstances.
If your franchisor requires you to buy supplies and equipment only from the
franchisor or from vendors designated by the franchisor, you will buy nothing on
prices that are competitive. You will always pay more for everything than your
independent competitors who are not franchisees. The reasons given are quality
control, but today that is just nonsense. There are many vendors of high quality
equipment and supplies, and merely requiring that what you buy meet generally
accepted commercial standards for a stated quality level would adequately
protect any quality control interest. The real reason for this tied in provision
is that the franchisor will derive an additional revenue stream from your
operations. While the FDD may disclose that the franchisor derives revenue from
these commercial relationships, they don’t tell you how much. You can fairly
assume that you will be overcharged at least 25 % for everything you buy
compared to any intelligent independent business operator in your same business.
Quiznos franchisees, for example, blame this game for their inability to make
profits and for the demise of hundreds of franchisees. Quiznos franchisee
population drops markedly every year. That pattern is also the signature of
every opportunistic franchisor’s system. Payments to your franchisor for sales
made to you should be coming to you or to your independent franchisee
association. In franchise systems that have effective independent franchisee
associations, that is how it works. Really profitable franchisees, like Popeye’s
Fried Chicken, do it that way. In 2009, Burger King tried to grab off vendor
payments by soft drink vendors, and only the BK franchisee association’s
militant opposition prevented that from happening. You can’t afford to be a
franchisee in any system without a militant independent franchisee association.
This is by no means an encyclopedic treatment of the risk factors in buying a
franchise. It is at best an aggressive heads up on why you can’t do your own due
diligence without a lawyer who vets the deal as well as the legal documents. A
lawyer who can only explain legalistics and not the deal dynamics is useless in
pre investment due diligence. You have to ask the lawyer you are thinking of
hiring whether he does just the legal documents or also does due diligence on
the quality of the deal itself. Most don’t.
There is a lot of fluff in franchise selling. You are in business by yourself,
no matter what anyone tells you. Your contract says that you get the support
that your franchisor happens to be providing at the time, from time to time,
without specifics. In one system of my experience, when franchisees called in
with problems, the support response consisted of “Thank you for sharing that
with us.”
You are not a member of anyone’s family. This is an arm’s length business
agreement to which you will be bound even if you completely lacked understanding
of what you signed. It is written in such manner that you agree to do as you are
told, when you are told, even if it changes (the operations manual can be
changed whenever the franchisor feels like changing it), while the franchisor
can do pretty much anything it chooses.
Compare the sections under Duties of The Franchisee with the section on Duties
of the Franchisor.
How much of what you were told in the sales and marketing brochures, in the
sales pitch itself, and on discovery day is actually provided for in those terms
in your franchise agreement? The answer, on close scrutiny, is almost none.
If the franchisor is a publicly held company, compare its SEC filings for the
same year against the FDD. The glowing bullshit descriptions in the FDD and
marketing materials will be seriously contradicted in many important issues by
their filings with the SEC. In the FDD, for example, it will describe the market
for your products or services in glowing terms. In the SEC filings you will see
a more realistic statement of affairs. And that is only one example of
contradictions that ought to make red lights and sirens go off in your head
about who you are thinking of signing a long term contract with.
In the dispute resolution provisions of your franchise agreement, you will be
disadvantaged at every possible turn. The law of the franchisor’s state will
govern. Dispute resolution must be done at your franchisor’s HQ location. You
may not be allowed to sue. You make have to mediate and arbitrate everything, an
extreme disadvantage. Most arbitrators come from large law firms that seek out
franchisor business and have a decided bias about not deciding anything against
the franchisors’ interests. If you are all owed to sue, you often have to waive
trial by jury and waive claims for lost profits and punitive damages, no matter
how outrageous the franchisor’s behavior may have been.
If you are looking at an existing business, franchised or not, there is more to
do than just read documents. Everyone has baggage. Somebaggage is high class and
much more is not. You need to now the mix.
Look at the location as though you were inspecting a room. Is parking adequate
when the place is busy? Is the parking area clean and in good repair? If there
is a dumpster, is it full and smelly or well maintained? Hire an engineer to do
a thorough workup of the place, structural, electric, plumbing, equipment,
safety, codes compliance, everything. You can’t afford not to do that. Walk the
neighborhood and see what is lying around that comes from this business. Is the
current owner a good neighbor or a slob? Every negative thing you can find will
reduce the selling price. Browse other businesses in the area. Get a feel for
the general area. That could reflect things that will negatively impact this
business in the future under your ownership. Chat up people in the general area.
Locals will tell you everything you might want to know so long as you seem
simply to be a gossip lover and don’t tell them you are a potential buyer.
Employees will tell you everything, especially if you pick up a tab for some
beers where they drink. Follow them to see where that is. If the place is a
restaurant or has a bar, being a great tipper will get you more news than you
ever thought could exist. Watch the bartender if there is a bar. Odds are that
he knows the place is for sale and that he is giving away drinks to enhance his
tips. Make note not to employ him if you buy the place. If there is food, order
the high priced items and see what you get.
Get good looks at the back of the house. That is where the darkest secrets are,
many of which can be learned by simply inhaling. In a restaurant, look in the
coolers, all of them.
Visit on different days and at different times. Every place has patterns. The
more you can do before you are identified as a potential buyer, the more open
everyone will be with you. Scout the place for a few weeks at least before
anyone knows what you are doing there. Go to the fire marshal’s office and to
the health department and read the inspection reports. Go to the city/county
engineer’s office and find out if there are about to be major construction
projects in the area. A new street/road/highway may have the prospect to wreck
business. That could be why it is for sale. Do a lien check at the county
clerk’s office and at the secretary of state’s office. You can do that on line.
Meet the insurance agent who will see you as a prospective client. Get the
claims history on the place.
You
have or have access to upwards of close to a million dollars, considering
everything you have and everything you can borrow, in potential liquidity. You
are considering an investment in a small business.
The greatest way to reduce investment risk is to keep your money in your pocket
for six months to a year and go get a job – any job – working in a store, unit,
that is the same as the business you are thinking about. Even if you start in
some menial position at or close to minimum wage, the time spent working there –
if you are paying attention – will tell you more about the business than you
will ever learn from any other pre investment due diligence. And you will still
have all your money in the bank and not have signed any agreement limiting what
you can do with your life. You don’t have to tell anyone that you are doing this
to see if you want to buy one. In fact, that is the last thing you should ever
tell anyone.
Compared to risking everything you own and everything you can borrow and
restricting your rights to do what you want for the next seven to twelve years
(the period of a franchise agreement plus compliance with the post franchise
covenant not to compete), this kind of due diligence is pure gold.
You aren’t going to make a profit from the investment you are considering for
over a year anyway, so being paid even minimum wage is a good bet by comparison.
You won’t have signed any agreements. You won’t be in debt on any start up loan.
If you don’t like the business after you have worked in one just like it, you
can walk away unrestricted with no debt.
You absolutely cannot beat this kind of pre investment due diligence.
There aint no taksey backseys in this game. Once signed on you will find that
nothing is what they told you it was going to be like. Nothing is going to be
better than they told you it was going to be. When you discover that you have
been screwed you probably won’t be able to pay the cost of dealing with it using
a trial lawyer. Unfortunately, those are the sad franchising facts these days.
The government is not going to come to your rescue. You have absolutely no
rights on this earth that are self executing. You have to defend yourself at
every turn or someone will assault your financial position and leave you and
your family in poverty. The law that prohibits franchise fraud does not prevent
franchise fraud any more than the law prohibiting murder prevents murders. What
you learned in government class was not true then and it is not true today.
Finally, you will learn so much about that business that you will probably be
able to go into that business as an independent with no obligation to pay anyone
for the privilege. If you’re really smart, this is how you will go about your
pre investment due diligence investigation.
Copyright 1997 - 2010 || Richard A. Solomon
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