Former Administrator Talks About Red Flags of Franchise Fraud

Editor’s note: Attorney Bob Tingler, the former Franchise Bureau Chief with the Illinois Attorney General's office, has posted a couple of comments in response to a Blue MauMau article that described banks receiving bogus financial earning expectations from franchisors, while the actual key franchisee investors (the buyers) are being left in the dark. For many years Tingler was the person in charge of safeguarding the interests of franchisees while he led Illinois' efforts to administer and enforce franchise and business opportunity laws. His two postings regarding red flags in buying a franchise are compiled in a single article below.

[To Blue MauMau Readers]

These are hard lessons learned that too often are not passed on to new prospects. It is unfortunate that prospective franchisees frequently believe that franchise regulation is a stamp of approval for each franchise system being offered. There are benefits that flow from existing regulations and they have grown from experience and a belief that franchising is a unique form of doing business that should have some basic protections, as compared to the new prospect that wants to own their own business and buys a non-franchise enterprise from an existing owner. The person who starts their own business from scratch, or buys an existing business, seems to better understand that critical information is not automatically required, deceptive information may be volunteered and a lot of due diligence is essential.

There is no excusing the fraudulent franchisor, broker or catatonic banker, but the prospective franchisee has to take the mandatory disclosure document for what it is - a head start for the buyer, who must go much farther in gathering information and not be lulled into thinking that their new, experienced "partner" (the franchisor) and the other cast of characters, are friends rather than salespeople who are determined to close the deal.

A good franchisor will force prospects to ask a lot of pertinent questions because management knows that a well informed, team player will make a long term, good franchisee. The mere fact that a franchisor would try to make a quick sale and not make a great effort to be sure the prospect understands exactly what they are getting into should be a red flag that causes a buyer to look elsewhere. When the franchisor claims it forbids its representatives from providing performance data for its franchisees, but someone gives out the information anyway, the prospect should break off negotiations. If the franchisor in fact does not provide such data, the prospect should seek the information from as many existing franchisees as it takes to be satisfied that a buying decision could be partially based on the performance of the desired franchise system.

There are virtually no hints in the threads to this article, that indicate due diligence included face-to-face interviews with existing franchisees to learn what their experience has been regarding the franchisor's conduct; the actual performance of the existing franchises; and the prognosis of those franchisees as to what their business will look like in five or ten years. I know lawyers and accountants, including some who already have personal business experience, who will never enter a business deal for themselves without consulting knowledgeable experts and doing their own investigation of what is being offered. They will not make a personal guarantee that includes their home, without considerable evidence that the proposed venture could work and that the seller's information is valid. However, none of the regulations and additional due diligence will insulate the franchise buyer from people who intend to mislead or defraud.

About fifteen years ago there were serious discussions among state and federal regulators about making Item 19 [store earnings claims] disclosure mandatory and the subject came up again during the FTC's most recent decade of rulemaking procedures. This proposed regulation was determined to be unworkable. Even if this rule was implemented, it would not have cured the problem of the unethical franchisor or broker, although it might have provided more proof to a court of law.

The #1 recommendation I have made to hundreds of prospective franchisees and attorneys representing them is to interview several existing franchisees and a few former franchisees, and to pick the most cooperative and knowledgeable franchisee to ask if the prospect could work along side the franchisee for free during a two week period to learn more about the business and verify the prospect desire to buy.

Buying a business, and particularly deciding to take on a any kind of a "partner," should be as significant a decision as getting married, but we all know of people who have not been cautious enough before making either choice.

[Blue MauMau Note: Second comment post follows]

I did not want to overstay my welcome with too long a comment about due diligence and getting performance information from present and former franchisees. However there seem to be some pessimistic opinions about approaching existing franchisees that I thought I should clarify my thoughts.

When I mentioned interviewing franchisees, I meant face-to-face, repeated discussions, with as many franchisees as it takes to believe you are getting real answers to your questions. Although it may not be as valuable compared to interviews, you can also learn a lot by spending a few hours a day in the franchisee's parking lot watching the traffic and going inside for awhile to see how business is conducted during peak times. If you can do volunteer work at a franchise you should be able to learn a lot by just observing what typical days look like - even if the owner seems worried about opening up to you. At some point during your attempt to build up trust in each other, invite the owner and spouse to go out to dinner or lunch with you and your spouse. You may learn a lot more by casual conversation with the owner's spouse and in the process win over the owner.

Find out from your local government how much sales tax was paid by a few of the system's franchisees and extrapolate what sales figures produced the tax figure. Then ask those franchisees directly for such figures (+ expenses if possible) to see how they compare with franchisor and franchisee sales figures. Try to learn how much the average customer spends with the franchisee - a figure some of the franchisees may be willing to divulge. Do the math and determine how many customers would have to spend "X" dollars to produce "Y" sales volume. Is the result humanly possible? Will your projected costs leave enough revenue to sustain your family and allow growth?

Find out if there is a franchisee association (company sponsored or independent) and make a point of meeting the President or Board members of the association(s) and try get their sponsorship to meet with franchisee members and really talk about their business. Ask if there are any conflicts with the franchisor and how the franchisor has responded to problems. Having some problems is to be expected (if they say there have been zero problems, run away), but how the franchisor deals with each problem is very critical to understanding how you will be treated.

Look for franchise sites that are operating and for sale and approach them as a buyer who naturally will want to see the books and records, including tax returns for the business. Their attorney may want you to sign a confidentiality agreement regarding the records and business practices that they discuss with you, which should be acceptable to you so you can learn a lot more about the performance of that business. Hopefully they did not lie too much in their tax return.

Involve your attorney and accountant in your due diligence, and depending upon where you live, look for franchise experience in each professional's background. If you cannot find local talent, working with franchise experts is important enough that you should consider using experienced professionals that work a great distance from your home by mail,fax and "Go to Meeting" type software. Travelling to their office before you make the final move to buy, will be worth the investment - particularly when you consider what it will cost to get out of a bad deal.

If no one opens up to you because they are scared, maybe that isn't a business atmosphere you can tolerate for the next 20 years. Your most powerful asset when learning about becoming a franchisee and analyzing your business prospects, is being willing to say "no" and walk away from that deal.

Bob Tingler