According to a recent article on Forbes.com, approximately 300 new franchise concepts pop up every year. Of these, nearly a third (30.6 percent) sell zero or one franchise within their first four years of franchising, and less than half (42.2 percent) expand to 26 or more outlets five years from the issuance of their first Franchise Disclosure Document (FDD).
So, is buying into a startup franchise too risky? Or, if the concept proves successful, can it provide the sweet spot that many prospective franchisees are looking for – a recognized brand and reliable system support without the intra-brand competition and impersonality of a behemoth franchise system?
As with most things, it depends. The statistics certainly seem to bear this out, and they also shed light on just how much franchisees’ success can be dependent upon their franchisor’s efforts to build the system (despite the disclaimers in their franchise agreement that say otherwise). In order for the brand to grow, you need the franchisor to sell franchises. If you are the first franchisee to buy, you could also be the last; or, you could be an early adopter who gets to benefit from your ambition.
Legal Considerations for Buying into a Startup Franchise
Regardless of the franchisor’s experience, buying a franchise is a risky investment that requires thorough due diligence and careful planning and preparation. From a legal perspective, here are some of the key factors to consider:
- The Franchisor’s Expansion Plans – If you will be one of the first franchisees (or the first franchisee), how confident are you that the system will continue to grow once you buy? Especially at this early stage, the franchisor should be willing to share information about its expansion plans in order to help you gain a sufficient level of comfort with your investment.
- Projected Openings vs. Actual Openings – Each year, franchisors are required to published updated franchise sale and opening projections in Item 20 of the FDD. Has the franchisor met its projections to date? If not, what explanation can it provide, and what changes has it made to meet its revised projections going forward?
- Termination and Liquidated Damages – Many startup franchisors adopt “form” franchise agreements that are not specifically-tailored to the unique aspects of their franchise systems. These form agreements often include strict termination provisions and liquidated damages clauses that require franchisees to pay “lost future royalties” if their franchise is not successful. While these types of provisions are rarely fair, they make even less sense in the context of a startup franchise, and you may need to negotiate these provisions in order to avoid an unreasonable risk of post-termination liability.
- Modifications and “Upgrades” – As the system grows and matures, the franchisor may want to make changes. As a franchisee, you will need to comply with any required modifications or “upgrades.” However, as one of the first franchisees, you may have leverage to negotiate certain concessions or contributions so that you are not forced to serve as a guinea pig at your own expense.
For some additional considerations, you can read: Considerations for Choosing Between New and Established Franchise Systems.
Are You Thinking About Buying a Franchise?
Franchise lawyer Jeffrey M. Goldstein has over 30 years of experience representing franchisees and dealers. If you are thinking about buying into a startup franchise and would like more information about the risks involved, you can call 202-293-3947 or contact us online for a free initial consultation.