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Why Is It Important To Review The Franchisor’s Audited Financial Statements

Why is it important to review the franchisor’s audited financial statements? If the franchisor is financially weak, the franchisor may go into bankruptcy. A franchisor’s bankruptcy leaves the franchisee in a very difficult, and often unclear, position.

A franchisor should have sufficient financial strength to meet all of the obligations owed to the franchisee. In my opinion, a franchisor, even a start-up franchisor, should have more funds available in its bank account than the high end of the Item 7 disclosure. Item 7 of the Franchise Disclosure Document (FDD) is a chart that shows (in a range) what it is likely to cost the franchisee to open the business and operate it initially. A franchisor should have at least the funding in its own bank account that meets the high-end of the range stated in Item 7. How can a franchisor possible meet its obligations to the franchisee (training, real estate assistance, grand opening assistance, etc.) if it is not sufficiently funded? I was contacted recently by a prospective franchisee of a relatively new system in which the franchisor had less than $100,000 in assets. The franchisor’s financials indicated that it was quite weak. However, the investment by the prospective franchisee would have been greater than the value of the franchisor’s financials. In all the states in which the franchise was registered (except New York State), the state required that the franchise fee be deferred until after all of the franchisor’s initial obligations to the franchisees of that state were met. In other words, the franchisor was required to forego taking the franchise fee until after the franchisor trained the franchisee, helped secure the required software, etc. The prospective franchisee decided to retain an accountant to evaluate the financials to determine if he wants to move forward. That is a smart move on his part so he can make a more informed decision before he moves forward.

In my opinion, the review of the franchisor’s audited financial statements can be a critical piece of information in making an informed decision before you move forward with a franchise opportunity. In addition to speaking with existing franchisees and reading the 23 Items of disclosure in the FDD, evaluating the financials of the franchisor should be an important part of the process (see a prior blog post on this topic: Four Steps To Validate A Franchise). Years ago I was in-house counsel to Nutri/System, Inc. At that time Nutri/System was the number 1 weight loss company in the U.S., had been in business over 20 years and had over 1300 franchised locations (and 500 corporate). When they went into bankruptcy, it did not take long for the franchised locations to close. It is very difficult for a franchisee to survive the bankruptcy of its franchisor. All the economies of scale that make a franchise feasible for the franchisee to succeed are lost when the franchisor is no longer available.

Why is it important to review the franchisor’s audited financial statements? Because the franchisor should be strong enough to support the franchisees that are in the system and the growth that a franchisor anticipates. A weak franchisor means that it may not be able to provide the support anticipated or promised and, even worse, may go into bankruptcy, leaving the franchisees in a very difficult position to survive without the support of the franchisor.