Assessing the health of a franchise system is an important part of any due diligence process. Doing so will inform your decision and help to evaluate the risk of investing in a business model. When reviewing the health of a system, one should look at the system holistically, individually weighing key areas that contribute to the overall health of the system.
Gauging a brand’s strength in the following components is a good place to start when doing your own assessment of a franchise system’s overall health. Independently, certain pieces of data may not be necessarily good or bad indicators of overall health, therefore we encourage you to look at the context of any figure and see how it fits into the whole.
- Brand recognition and differentiation: Look at what the brand is doing to stay ahead of its competitors. Has it differentiated itself within its industry and demonstrated staying power? Has it captured a considerable market share and is there widespread brand recognition?
- Growth: Item 20 in the FDD will tell you whether the brand is expanding or contracting. Ask questions about the brand’s growth, or lack thereof. Also, consider at what rate this is happening. Steady growth is always a good sign.
- Business model: The business model should prove to be successful and easily duplicated. Can you make a living from it? More so, is it a good return on investment for franchisees? Earnings claims can be found in Item 19 of the Franchise Disclosure Document.
- Company owned stores: Look at whether the brand has any company owned stores. This shows that the business model is sustainable and profitable, showing they can run their own stores. The presence of company owned stores allows a brand to test new systems and ideas before rolling them out system wide. Sport Clips Haircuts, for example, has 69 company owned stores and is leverage those stores to test out new ideas and optimize processes to maximize revenues.
- How the franchisor makes money: Does it make more of its money from the initial franchise fees or from the recurring royalty fees? A low ratio of franchise fees to royalties is the sign of a mature system that is not reliant on franchise sales for financial growth and stability. It is a sign of a healthy operation when the majority of its earnings comes from current and successful franchise owners, as it has a more vested interest in franchisee success.
In 2016, for every dollar of revenue Sport Clips earned, 77 cents of that was recurring revenue from continuing fees and product sales. Sport Clips also does not receive kick-backs from products and they do not make a profit from the store buildout. These characteristics are all indicative of a stable and healthy system.
- Litigation history: It is also a good idea to look at the company’s litigation history in Item 3 of the FDD. While a low level of litigation is ideal, zero litigation should be concerning as well. A franchisor should be willing to take the necessary steps to protect a brand. A pattern of excessive litigation would also be a red flag though. Consider the type of litigation and see how they company handles conflict.
- Turnover rates: A high number of transfers is a sign of a healthy system, whereas a high number of terminations and non-renewals are unhealthy signs. A high number of sold but never opened licenses should also raise concerns. These numbers can be found in the FDD’s Item 19.
- Multi-Unit owners: Does the brand have multi-unit owners? If it does it means the model is scalable and that franchisee success is supported and most importantly, achievable.
- The selection process: The selection process should be rigorous and thorough. Financial requirements should be high. It should be about deciding if the business model and brand are a good fit for both the potential franchisee as well as the franchisor. Is the franchise system awarding franchises to franchisees who are a good fit, rather than just collecting franchise fees?
- Second generation owners. If a franchise has been around for a while, are there any second-generation owners? This speaks to longevity of the system.
- Franchisor/Franchisee relationships. What are the support systems in place to help franchisees be successful? Is there marketing and advertising support? Is this support at the national, regional and local level? Is there support to get up and running, but also to keep growing? Read more about how to find clues about a company’s culture in its FDD here.
- Leveraging buying power. Does the brand facilitate access to suppliers and vendors? Look at Item 8 for supply and inventory arrangements. You should see the brand leveraging its buying power for its franchisees.
These are a few areas to look at when evaluating the health of the franchise system you are considering. If a system is healthy you may minimize your risk and can be more likely to find success in meeting your personal and financial objectives.