Thoughts on Due Diligence & Exclusive Territories
Why does this site often post negative horror stories about franchisees who don’t do enough due diligence or franchisors who appear to take advantage of naive entrepreneurs? Because the “scared straight” method often works, and you’ll be happy you spent a little extra time researching the financial and legal aspects of the business. The franchise salesman and commissioned consultants rarely fully apprise the franchisee of the risks and obligations from entering into a legal contract that could potentially have the franchisee on the hook for hundreds of thousands of dollars.
Franchising can be wonderfully prosperous and rewarding endeavor, or it can be an angry and bankrupting experience. The later can usually only be controlled BEFORE you pay the franchise fee and sign the franchise agreement. For example, if your franchise agreement grants the exclusive territory in such a way that another location can be theoretically constructed 2 blocks away, perhaps you are best to walk away if this will obviously overly dilute your customer base to the point of unsustainable sales. Franchisors are notorious for milking profitable locations by stacking franchises as close as legally possible. Why? Because franchisors make more money from each additional $25K franchise fee plus the additional gross revenue, and two stores will always gross more than one. Some poorly organized and managed franchisors get themselves into a virtual Ponzi scheme where the company must keep earning increasingly more franchise fees to support their growing franchisor operations that is not sustainable by royalties alone. If the franchisor won’t carve out a territory big enough for you to make a comfotable profit, you don’t have to ask why, you know why.
Here is an extreme example (Caught in a Franchise Fiasco, The Toronto Star, Mar. 14, 2006) of what can happen when the franchisor-franchisee relationship evolves in unanticipated ways.
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How much do the franchise consultants make and who pays them?
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The Toronto situation is largely result of (2) problems. First, unlike California, there is no free public access to the franchise disclosure documents. Second, these particular franchisors are crooks - straight out and out criminals. It is very hard for the ordinary lawyer, let alone franchisee to detect this. While most franchise agreement are horribly one sided, there are not that many out and out crooks.
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