How to uncover a chain's dark secrets

Franchise relationships are notoriously lopsided: The chains demand to know every detail of a prospective franchisee’s financial health, but they are often under no obligation to divulge anything about themselves…Financial questions may only be a small part of the investigation for buying a franchise. But they often lead directly to other important considerations. And if there’s no financial information, there may be something to hide.

The Globe and Mail
September 1997

How to uncover a chain's dark secrets
John Southerst

Franchise relationships are notoriously lopsided: The chains demand to know every detail of a prospective franchisee’s financial health, but they are often under no obligation to divulge anything about themselves.

The absence of disclosure requirements in most Canada makes a mockery of the franchise industry’s exhortations to “investigate before you buy” and “do your homework.”

If the franchisor operates in Alberta or the United States, or if it is a public company, it’s possible to get some information on financial stability. But most privately owned franchisors keep their books closed.

The Canadian Franchise Association, representing about 300 of the more than 1,000 chains operating in Canada, requires the disclosure of some useful information, but not financial figures.

What dark secrets lurk on the books of Canada’s franchisors? You’ll probably need the opinion of an accountant with experience in this area to get a precise reading. But there’s plenty to check out yourself:

Is the franchisor more interested in selling franchises or building healthy outlets? A disclosure statement should show various sources of revenue. Some franchisors earn the bulk of it from royalties on outlet sales, others from franchise fees, product distribution (including markup to franchisees) and rent from properties they own. Determine the origins of big parts of a franchisor’s income and you will begin to understand where its interests lie.

Is it reimbursed over the long term through royalties and distribution of goods, or up-front in fees? “Ideally,” says Ian Hamilton, senior manager of national franchising services for Bank of Montreal, “most income should come from royalties.”

If this is the case, the franchisor is likely doing everything possible to promote franchisees’ sales and to develop productive outlets.

“But you can have early stage systems that are growing very rapidly with a large percentage of income coming from franchise fees and not much yet from royalties,” Mr. Hamilton adds.

This isn’t necessarily bad, but it should trigger questions: How long does the franchisor expect to continue to grow at this rate? Is there any indication it is spending enough time and resources on supporting existing franchisees?

Is the markup fair? Check income from product distribution. If it is a large proportion of total revenue, ask about the markup. “Make sure the franchisor is not abusing franchisees with excessive markups,” Mr. Hamilton says.

Some of them may not divulge the amount – perhaps they are protecting information from competitors. So shop around to see how their prices compare with other wholesalers. “If you can buy locally for less than the fanchisor’s price,” Mr. Hamilton says, “you can be sure the franchisees will be up in arms.”

Do fees collected for advertising and promotion at least match the franchisor’s spending for these purposes? Make sure the chain is spending what it collects. Until about five years ago, many franchisors treated advertising contributions as unallocated revenue.

“They should really be spending more than they collect because the franchisor should be making a contribution,” says Douglas Fisher of FHG International Inc., a Toronto management consultant specializing in franchising.

Does the franchisor invest in the future of the system? You should be looking for commitment to the business, Mr. Fisher says. But how can you tell? Look for spending on training and human resources, and find out whether there is a senior manager in charge. Promotion and advertising budgets are also important system builders – together, they should add up to 3 to 10 per cent of gross system sales, not including royalties.

Does revenue exceed expenses? When franchisors go to the bank for a loan, they usually borrow against cash flow. They don’t have many assets because stores are owned by franchisees. That’s why, for them, cash flow is the same as royalties.

A healthy flow of royalties indicates not only a vigorous system where the brand and franchisees are successful, it also means the franchisor possesses borrowing power.

Are the assets strong enough to withstand a recession? Recessions come every seven to 10 years – a sobering thought for someone entering a 10 year franchise agreement. Could your chain survive if a lot of franchisees didn’t pay royalties regularly?

To get an indication, take the franchisor’s total debt, including long and short term loans, and divide it by shareholders’ equity. Restaurant chains should not carry much more than a 1-to1 ratio of debt to equity, Mr. Fisher says, while other franchisors should not exceed 3 to 1, depending on other factors.

“Check that there’s no overleveraging of assets to buy other companies or to take on other excessive debt.”

Are there irregular accounting practices, major outstanding lawsuits or other unusual financial considerations? Review the notes to the financial statements, which are usually in fine print at the end. This is where accountants must report on outstanding situations. They can make interesting reading.

Financial questions may only be a small part of the investigation for buying a franchise. But they often lead directly to other important considerations. And if there’s no financial information, there may be something to hide.

John Southerst is a Toronto business writer who can be reached a moc.eriw-eht|htuosj#moc.eriw-eht|htuosj


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