This is a guest blog post by Elliot Ginsburg, an attorney at Minneapolis-based firm Garner & Ginsburg, P.A.
Buying a franchise can be an excellent opportunity. From the start, you may get to take advantage of an already recognizable brand without having to worry as much about the marketing aspect of the business. However, there are pitfalls and risks involved, and something you should be on the lookout for from the get-go: fraud.
First of all, what is franchise fraud?
Franchise fraud is any type of misrepresentation that a franchisor or franchise broker makes to induce someone to buy a franchise. Typical franchise frauds include statements about how much money the prospective franchisee will make, how many franchises are in the system and how much it will cost to build out the franchise.
Brand new franchisors are more likely to engage in misrepresentation than established franchisors. Also, franchise brokers, who bring together franchisors and those wishing to buy franchises, sometimes engage in fraud because they get a substantial commission on the sale and may not have to live with the consequences: once the sale is made, they are gone.
The Franchise Disclosure Document (FDD)
Under FTC law, you should receive a franchise disclosure document (FDD) at least two weeks before signing any franchise agreement or paying any money. This document contains 23 items of information, including the franchisor’s background, litigation history, any bankruptcy information, restrictions in terms of suppliers, territories and customers, initial and ongoing costs, the franchisor’s financial statements and more.
If you are considering buying a franchise, make sure you have a verifiable and complete FDD in hand and read it carefully. You can find more information on all items contained within an FDD by reading A Consumer’s Guide to Buying a Franchise at FTC.gov.
Dependent upon the state, a franchisor may be required to register its FDD. The absence of a franchisor from the registration rolls in such a state could — but not necessarily — be a warning sign (some could be exempt). States with franchise registrations include California, Illinois, Maryland, Indiana, Hawaii, Michigan, Minnesota, New York, Wisconsin, Rhode Island, Virginia, Washington, and North Dakota.
While the types of fraud and misrepresentation are limited only by the imagination, some telltale signs of possible fraud include the following:
- Statements of how much money the franchisee will make if they are not contained in the FDD, especially in-person presentations that use spreadsheets. A “red light” is when the franchisor will not provide a copy of the presentation.
- When the franchisor gives the prospect a list of a handful of existing franchisees to contact for “validation” of the franchisor’s claims. These franchisees may be getting paid, directly or indirectly, to talk up the franchisor. The practice is forbidden by the FTC and is known as “shilling.”
- In brand new systems, statements about the costs of building out and equipping the franchise. Costs for building a franchise can vary tremendously, and without a long track record, the franchisor can’t really provide reliable estimates.
Starting a franchise is a lot of hard work in the best of systems, and it may be the biggest single investment you make. It’s important to be as careful as you can, and make sure you have an experienced lawyer or advisor looking over your shoulder before you dive in.
For more information on this issue, read, What Is Franchisor Fraud? When Are Misleading Statements Actually Fraudulent? from Garner & Ginsburg, P.A.
Elliot Ginsburg is an attorney at Minneapolis-based firm Garner & Ginsburg, P.A. His specialties include franchise and distribution law. Ginsburg graduated magna cum laude from University of Minnesota Law School in 2010 and has had experience representing companies in the automobile, food, energy, hotel, brewing, and medical industries.