What You Need to Look Out For In a Franchise Deal

If these words come up in a franchise deal, walk away

Negotiations over a potential franchise deal can be difficult since there are several aspects that need to be hashed out. However, before the terms are even laid out, prospective buyers need to be aware of several red flags.

These range in severity, but they could prove to become serious problems down the road:

1. Litigation involving the current franchisee

Litigation is common for most franchises. However, multiple open lawsuits are a red flag; particularly if the franchisor is involved with several suits against its own franchisees. Not only is this a potential risk for the franchisee, but it’s also alarming for the franchise system itself. This is particularly concerning especially if litigation is resolved with drawn-out lawsuits, because the prospective buyer could see a substantial portion of his or her profits impacted in the future.

2. No designations for protected territories

Without designated territories for a franchise, the prospective owner could face new entrants in his market – even from franchisees in the same franchise system. According to a recent CNBC report, there is a tremendous window of risk that prospective owners walk through if they sign a franchise agreement without proper designation of protected territories.

3. Renewal rights are not perpetual

Perpetual renewal rights clauses in franchise agreements are vital, specifically in the event of a future sale. With term franchise deals, let’s say for 10 years, any attempt to sell the franchise without a perpetual renewal rights provision makes the business significantly less valuable. Prospective buyers will not want to buy a business that will run out after the 10th year, and your ROI will be much lower than expected after years of building the business.

4. Be wary of depreciated value

This is perhaps the most complicated red flag on the list. According to CNBC, this could also prove to be the most financially devastating for franchisees. If a buyer wants to acquire the company years later, or if the franchise company wants to buy the business at the end of the ownership deal, and there is no provision included in the prospective owner’s current franchise agreement against depreciated value, it could cost the franchisee dearly.

If a buyer is allowed to acquire the owner’s franchise at the “depreciated cost value of assets”, it substantially lowers the value of the owner’s net profits on the sale. The way this works is that regardless of the owner’s gross sales and net income, prospective buyers will only calculate the depreciated value of the initial investment. CNBC provided an example: If the owner held the franchise for 20 years with a $500,000 investment, that depreciated value could be $20,000. Needless to say, that is a potentially crippling blow.

5. Closings of other franchisees

This is an obvious aspect to look out for because you want to gauge how many franchises have closed or opened recently, according to a QuickBooks Intuit report. In the case of Pink Berry for example, this was a popular franchise with a growth spurt that sold a lot of new units. On the flip side was Chipotle, which was a once popular franchise that recently closed several stores, showed how a company’s growth potential could change instantly with consumer preferences.

“…the issues listed above not only expose you to risk, but also to financially devastating consequences in the event of a future sale.”

Bottom line for prospective franchisees in a franchise deal

These are just a few examples, but you should walk away from the negotiating table if any of these red flags come up. The issues listed not only expose you to risk, but also to financially devastating consequences in the event of a future sale.