Ask the Experts - Investigating a Franchise
By Rick Chittley-Young, BDO Dunwoody LLP
FranchiseCanada Magazine
Published June 2004
Q: What role will my accountant play when investigating a franchise?
A: Becoming a franchise owner could be one of the best business decisions you ever make – or, it could be one of the most disastrous.
Only you can reduce the personal risks involved in starting and working in your own business – your accountant, however, can help you objectively assess and mitigate the financial risks.
By involving your accountant as a “risk reduction specialist” when investigating prospective franchise investments, you increase your chances of success. An accountant experienced with franchises and small businesses can provide objective, experienced counsel along the way. Following are some of the financial risks this professional can help you to reduce or eliminate.
The risk of selecting an unprofitable franchise
One of the advantages of the Franchise Disclosure Act, which came into effect in 2001, is that the compliance burden it imposed on franchisors weeded out many frivolous franchise concepts. The Act’s requirements to provide detailed disclosure documents to interested parties has contributed to a more professional franchise sector in this country.
This is not to say, however, that all franchises offer prospective franchisees the guarantee of a successful business. Significant risks remain, and it is up to every prospective franchisee to carry out the appropriate due diligence before making a commitment.
Your accountant can help you reduce the risk of selecting an unprofitable franchise by taking a measure of the financial health of the company through an analysis of the disclosure documents. The Act requires franchisors to provide detailed documents to prospective franchisees at least 14 days prior to signing an agreement. Many franchisors will provide these documents when a prospect simply expresses interest in a franchise.
Once you have narrowed down your franchise considerations to a particular market sector, it would be a good time to consult with your accountant. An experienced accountant will know the best players and opportunities within each niche. He or she can discuss with you your needs and expectations, experience and financial situation and then help you focus your search on the most appropriate one or two prospects.
Then, it’s time to “take a look at the books.” Among the documents and information that a franchisor would provide to you under the terms of the Franchise Disclosure Act are the following.
- Information about any franchise agreement terminations, ownership transfers or bankruptcy or insolvency proceedings involving the franchisor or any of its directors, officers or partners. Looking at this information can point out any history of financial misdealing or errors on the part of the business and those who manage or direct that business, as well as any information that may adversely affect the success of the franchisees.
- Audited financial statements for the franchisor for the previous three years, including:
- a balance sheet, which indicates what the business owns and owes;
- an income statement, which shows what the company earns and spends; and
- a statement of changes in cash flow, depicting the flow of cash into and out of the business over the course of a year.
- A cash flow forecast or breakeven analysis for a typical franchisee, enabling you to see the amount of cash the business would require at different times of the year.
- All costs, fees and earnings under the terms of the franchise agreement: these include all franchisee costs related to establishing and operating the franchise; mandatory financial contributions, such as advertising; and terms and conditions of any financing the franchisor offers
By reviewing these documents, your accountant can help you determine the reasonableness of the information – and prevent the discovery of nasty surprises after signing a franchise agreement.
The risk of signing an unfair agreement
Agreements are another issue that pose significant risks. Owning a franchise involves signing, not only the franchise agreement, but also numerous other agreements, such as renewals, buyouts, leases and personal guarantees – each fraught with potential risks. It helps to have an experienced eye look them over to ensure they are reasonable, efficient for tax purposes and that they don’t include any unusual clauses.
We’re seeing more lease agreements today, for example, stipulating that leasehold improvements belong to the landlord rather than the lessee. When you are investing tens of thousands of dollars -- or more - in improvements, this could be an expensive loss in the event that you terminate your franchise agreement. You need to be aware of these potential pitfalls before you sign any agreement.
The risk that what the franchisor says is not what the franchisor does
Still, documents don’t tell the complete story. It’s often only when you talk directly with a franchisor that you can acquire the necessary insights to determine whether this is the right step to take.
While a prospective franchisee should always sit down and talk with the franchisor’s operational team, often it is helpful to facilitate a conversation between your accountant and one or more members of the franchise management team in order to address questions or issues.
The accountant knows where and how to probe for information and is alert to potential red flags. Often, it’s “six degrees of separation” -- somewhere during that conversation the franchisor will mention individuals or organizations with which the accountant is familiar; this can provide opportunities to conduct additional research with people who do business with the franchisor or its franchisees. The accountant can confirm the reasonableness and credibility of the information summarized by the franchise disclosure documents.
The risk that the franchisor does not have proper systems in place
Professional, reliable franchisors have well-documented systems, operations and marketing programs for their franchisees. While it’s unlikely that a franchisor will provide a prospective franchisee with samples of all of the relevant materials referencing this infrastructure, there will be some type of overview and you can also query franchisees regarding this documentation. This will give you a good idea of the scope and effectiveness of the support materials available to franchisees.
Again, it’s helpful to have your accountant review what you learn. He or she can assess infrastructure for internal control strengths and weaknesses. A franchise company with strong systems provides a strong foundation for its franchisees.
Overall, when you’re investigating a potential franchise, be sure to involve your accountant to help you minimize your risks – and maximize your opportunities for success.
Rick Chittley-Young, B Comm, CGA, is a principal of BDO Dunwoody LLP (www.bdo.ca) who works with franchisees and franchisors. BDO is one of Canada’s leading accounting and advisory firms, which helps businesses and entrepreneurs succeed. If you have questions about this article or would like to receive BDO’s “Tax Factor” newsletter, contact Rick in the Oakville, Ontario office at (905) 844-3206 or rchittley@bdo.ca.
