The process and prospect of buying into a franchise is an exciting one. However, prospective franchisees are advised to carry out a due diligence process to avoid letting their emotions cloud their judgement. If you’ve heard about due diligence as a necessary step in your research process but aren’t sure what it means, you’ve come to the right place.
In this article, we cover what due diligence is and the consequences of failing to follow this process. We also provide a due diligence checklist for purchasing a franchise business so that you can make a more thorough and informed decision. Let’s get started.
What is due diligence?
Although due diligence is a concept that is often used in business relations, typically in the case of mergers and acquisitions, franchise due diligence follows a similar process.
As such, due diligence for franchisees is a process of thoroughly investigating every aspect of the franchisor’s business so that you know whether or not the franchise opportunity is right for you. While it is a long, complex and arduous process, it is necessary to help you avoid some common pitfalls.
The consequences of not doing your due diligence
Some of the most common mistakes that prospective franchisees make include making uninformed decisions and not being a good fit for the franchise.
Others include underestimating the ongoing investment as you would not have spent enough time with the franchise owner or current franchisees to study the business and the market it operates in well enough.
This is why some frequently encountered consequences of failing to do your due diligence include:
- Making purchasing mistakes
- Not verifying details could be costly
- Making an unsound financial investment
- Loss of money and savings
- Potential lawsuits
- Personal dissatisfaction and stress
To avoid these costly mistakes and consequences, you want to be as prepared as possible. This is where a due diligence checklist comes in handy.
What is a due diligence checklist?
A due diligence franchise checklist is a list of items/documents/evidence that you will require from the franchise owner to help you reach a thorough conclusion about the business.
Often, such checklists involve certain questions to ask a franchise owner when completing due diligence. These questions are aimed to give you a lot more clarity and to ensure you go into the business as prepared as possible.
Franchise due diligence checklist
Having said everything above, it’s time to provide you with your ultimate due diligence checklist as you embark on your franchise purchasing journey.
The checklist below is divided into six sections, with some of these containing sub-sections for better understanding and organisation. Let’s take a closer look.
1. Legal due diligence
Legal due diligence refers to exploring and examining the franchisor’s business from a legal standpoint. Some of the aspects you will want to look at include:
- Articles of incorporation
- The franchisor’s business registration documents and amendments thereto
- The franchisor’s company bylaws, amendments thereto and written standards of conduct
- Minute book (with ownership and board meeting minutes)
- A list of all the current investors and shareholders
- A list of all subsidiaries and entities in which the franchisor has an equity interest
- A list of all the franchisors’ names and trademarked names
- All the locations where the franchisor has operations
- A list of all the products and/or services offered by the franchisor
- Assurance of business compliance
- A list of all the non-disclosure or non-compete agreements
- Letters of intent and contracts
- Distribution, sales and subscription agreements
- Contracts between all the officers, directors or principals of the franchise
- Certificate of Good Standing
- Documents related to reincorporation and restructuring
- Government licences, permits and consents
- Any documents related to proceedings initiated by a regulatory agency
- Material reports to government entities
- Documents and analysis of possible antitrust issues
- Pending or threatened litigation against the franchisor/by the franchisor
- All settled litigation against or initiated by the franchisor
- All active litigation files
- Any judgments, settlements and court orders
- Copies of attorney correspondence with auditors
- Any past/present government investigation
- All guarantees to which the franchisor may be a party to
- A list of the attorneys/solicitors with which the franchisor deals
2. Financial due diligence
With the financial aspect of your due diligence checklist, you will be looking primarily at the franchisor’s financial standing, income levels, profit and loss statements, etc. Below is what you need to consider:
- Income statements
- Cash flow statements
- Balance sheets
- General ledger
- Accounts payable and receivable
- Credit report and/or loan and bank financing agreements/lines of credit
- Tax returns for a period of three years or audited financial statements (inclusive of the auditor’s report)
- Debts and liabilities
- An analysis of gross profit margins and gross profits
- An inventory of all assets and their full value including equipment and real estate
- Purchase orders, quotes, invoices and/or warranties
- Future financial projections
- Budget and budget plans
- All auditor communication with management for the period of the last five years
- Depreciation and amortisation methods
- Changes in accounting methods over the past five years
- Any equity financing documents
- Deferred revenue
- Employment tax filings for a period of the last three years
3. Operational due diligence
Operational due diligence is a broad term that encompasses the franchisor’s operations. These are related not only to customers and employees but also to technological and physical assets. Here is a breakdown of each one in more detail:
Customers
- Sales records
- Customer databases
- Subscriber list
- Customer research data
- Purchasing policies
- Refund policies
- Pending litigation/threatened litigation
- Unsatisfied judgement
- Insurance policies and coverage
Employees
- A list of employees and an organisational chart
- Employment contracts and agreements with freelancers/independent contractors
- Payroll information and employee tax forms
- Human resources policies and procedures
- Employee benefits, retirement plan and insurance
- Disputes related to employment matters
- Employee non-disclosure and non-compete agreements
- Resumes of key figures in the franchise organisation
- Recruiting and onboarding process
- Copies of payroll documents
- Labour or employment contracts
Technological
- What software is used by the franchisor and copies of licensing agreements?
- Are there any outstanding IT outsourcing agreements?
- Current system age and usage
- Which interfaces link internal systems together?
- What processes are in place in the event of a disaster?
- What budget has been set aside for IT security and cost management?
- Have there been any previous data breaches in the past?
Physical assets
- All immovable property owned and leased (including the amount of rent, location, and dates)
- Sales and purchase of major capital equipment over the past three years
- Lease agreements for the equipment
- Real estate deeds, mortgages, leases, surveys, title policies, use permits
- A schedule of owned and leased fixed assets
- Equipment appraisals
- Practices regarding inventory ageing
4. Commercial/Product due diligence
With commercial or product due diligence, we now get to the heart of the franchisor’s business and what makes them competitive. In this regard, you should pay attention to the following:
- A list of products and/or services offered and in the development stage
- Market research
- Competitor profiling
- Top customers
- Customer analysis and segmentation
- Top suppliers
- Any barriers to entry
- Warranty claims
- A list of complaints
- Agreements with suppliers
5. Intellectual property due diligence
Intellectual property is one of the franchisors’ greatest assets. They have spent years refining and developing it. Therefore, it needs to be protected through the right channels and you need assurance in respect of the following:
- A list of all of the franchisor’s patents, trademarks and copyrights
- Pending applications and current registrations
- IP-related agreements
- Technical know-how
- All rights the franchisor owns
- All consulting agreements
- Active websites and social media accounts
- Custom software and IT systems the franchisor uses
- A list of all licencing revenue and expenses
- Trade secrets
- IP claims and litigation
6. Cultural due diligence
The final aspect of your due diligence process but by no means least important is cultural due diligence. This is something that has a more intangible nature but is critical to the success and strength of the franchisor’s brand. As such, you need to consider:
- The franchisor’s vision, mission, and values
- Interviews with external stakeholders
- Interviews with internal stakeholders/focus groups (e.g. current franchisees)
- On-site visits
- Internal and external questionnaires and surveys
Additional tips when conducting franchise due diligence
Of course, the list above is not exhaustive and it’s meant as a suggestion to help you get started when you begin your in-depth research process. There are several other aspects you should consider when conducting franchise due diligence. These include:
- Consulting with current franchisees
- Hiring a professional consultant/legal team
- Visiting on discovery day and asking the franchisor important questions
- Attending franchise fairs to gather more information
- Exploring the history of any possible franchisee failures, etc.
In conclusion
Doing your due diligence before you sign on the dotted line is possibly one of the smartest and most important things you can do to assure yourself of more peace of mind as you embark on your business journey.
And to make this process even easier for you, we’ve created a downloadable PDF with all the points mentioned above for easy access and use. Don’t hesitate to get your copy now!
And remember if you need any assistance with franchising, we are just a few clicks away. Get in touch with our team of professionals and we can help you make a strong and impactful decision that will benefit you and your business over the long term.
