Learn how to conduct due diligence to evaluate a franchise business opportunity.
Opening a franchise business requires a lot of hard work and dedication, and one of the most important steps happens before you ever put any money down or sign on the dotted line. Due diligence is a comprehensive risk and opportunity assessment that will provide the information you need to pursue a franchise business opportunity with confidence. Although time consuming and tedious, consider it a labor of love to ensure you’re making a sound investment. Knowing how to conduct due diligence, what to review and the advisors to lean on for assistance can help the process flow more smoothly.
What is Due Diligence
The phrase “due diligence” is used often and can mean different things depending on the situation. In a nutshell, performing due diligence for any endeavor simply means doing your homework. When opening a franchise business, due diligence means taking a deep dive into the franchise business opportunity that you are interested in buying. While you may already know top line information, you need to investigate the key elements of the business and the products or services you will be providing. Taking a good look at finances, legal documents and operational specifics can help uncover any deal-breakers that may not be evident on the surface. Before attempting any business acquisition, it’s imperative to do your due diligence to ensure the venture is worth pursuing.
How to Perform Due Diligence
Proper due diligence can be a long, complicated process but thoroughly assessing a franchise business opportunity is worth it in the end. It involves doing your own research to familiarize yourself with the business by digging through records, analyzing projections, investigating competitors and checking references.
Due diligence shouldn’t be done alone. Enlist the help of an accountant to review financial records and an attorney to review legal matters.
Assess the Finances
Financial due diligence involves evaluating the economic standing of the franchise business opportunity. Plowing through financial records can be a daunting task, especially if you aren’t sure how to interpret the information. Rather than take an uneducated guess, hire an accountant to weed through the numbers with you and properly evaluate the findings.
Study the Franchise Disclosure Document (FDD) to get an overview of the franchisor’s financial health. Pay special attention to income statements, balance sheets and cash flow statements. Look for irregularities in assets and liabilities and review historical trends from year-to-year to determine if the market is growing, shrinking or stagnant. A business should have a healthy cash flow, and you should be able to tell where the revenue stream is coming from. Review sales and gross profits by product to get an idea of what you may be able to expect as revenue once you become a franchisee.
As you review the financials, take a close look at annual projections. Find out how they were calculated and compare historical forecasts to actual results to get a feel for their accuracy. Note the size and value of all real estate, equipment and furnishings as well. Most importantly, ask for all business tax details to ensure that there are no surprises later.
Look for Legal Issues
Legal due diligence involves reviewing legal contracts and other documents to ensure there are no hidden risks or outstanding issues that could cause the business to incur liability. Seek the professional help of a lawyer to complete this important inquiry to make sure nothing is overlooked. All contracts such as leases, purchase agreements, distribution agreements, sales contracts and employee and contractor agreements need to be reviewed thoroughly. Be aware of all trademarks, copyrights, trade secrets and patents along with articles of incorporation and business registration documents. When it comes to doing business under the franchise brand’s name, do not make any assumptions. Your rights and responsibilities as well as those of the franchisor should be outlined clearly in legally binding documents such as the franchise agreement and FDD.
Operational due diligence involves investigating how the business is run and includes factors such as the business model, market and competition. Your review should reveal customer patterns, industry trends, competitive threats and how the business is perceived by customers as well as suppliers. Pay special attention to marketing expenditures to properly calculate ROI. Study past and present tactics and how well they performed.
The location of your franchise is important as well. Research the demographics and learn who the target customers are and how to reach them. What is the geographic economic outlook? Is the business located in a thriving area? Who are your competitors and what threats do they or could they pose to your business? You should already have a good idea of industry trends and profit margins by the time you reach this stage, but getting your hands on every piece of data available will help set realistic expectations of what life will be like as a franchisee.
Due Diligence is Imperative
Not completing your due diligence can result in more than simply buyer’s remorse. Aside from making a bad investment that can cause you to lose money, you could inherit an unknown debt or worse, a lawsuit. Opening a franchise business is a major investment in your future. Before you open your doors, make sure you know everything that’s inside by conducting a thorough due diligence review.