20 Tips to Avoid Buying a “Zombie” Franchise

20 Tips to Avoid Buying a “Zombie” Franchise

Opinions expressed by Contractor the contributors are their own.

“Zombie franchising” is out there. What is a zombie franchise? There is one that has stopped but is still marketing the franchise opportunity as if nothing is wrong. The brand typically shrinks in both relevance and number of open units. Previously loyal customers are being sucked away by more innovative concepts. Underlying demographics may have changed. Market trends may work against the brand, but management has not created a new path. The economy at unit level weakens. Management inertia or denial can compound the brand’s problems.

Zombie franchise systems are usually filled with franchisees who would love to quit if they could! Poor unit-level finances and an undercurrent of franchisee discontent are scaring away buyers, so resale volumes are low. Franchisees looking to expand look beyond the brand.

Related: 5 Strategies to Avoid the Most Common Franchisee Mistakes

Don’t get caught

New franchisees who miss the cues eventually realize their mistake. They may feel that the disclosures were inadequate or misleading. They often look back on conversations with franchisees and wonder how they didn’t hear the negative feedback. They may remember sunny conversations with consultants/brokers and the corporate team and feel cheated. Or maybe the company is really out of touch and doesn’t even realize there’s a problem! All of this destroys the franchisee’s trust and usually the relationship.

Franchisees in a zombie system are usually tied to the business with personal guarantees, a land lease, equipment or vehicle lease, a Small Business Administration (SBA) loan, a home equity loan, an investment loan or 401(k) or family loan and friends. The long-suffering franchisee can’t hire enough help because they can’t afford it, can’t sell the business, and can’t shut it down. They are essentially indentured servants.

Often these brands spend significant money on branding and advertising to try to convince potential franchisees that they are still worth investing in. They are trying to renew the sales of franchise units, but not the underlying business.

Related: 5 Things to Consider Before Owning a Franchise

20 characters of a zombie franchise

You’re too smart to be drawn into a weak franchise concept. Here’s a simple checklist to keep your due diligence on track and avoid zombie franchising. If you’re a founder hoping to sell to private equity, PE will screen out brands with these characteristics unless they’re dedicated flip investors, so fixing these issues becomes your to-do list:

  1. Lack of unit growth, especially via existing franchisees. Talk to as many franchisees as possible. If they don’t want to expand even though the territory is vacant, I recommend moving on.

  2. Weak profitability at unit level

  3. Unfulfilled development agreements. Franchisees would rather lose their deposits than follow through and open promised units. Item 20 of the Franchise Disclosure Document lists franchisees and holders of development agreements. Get in touch with these franchises.

  4. The corporate parent is far too dependent on selling franchises. Look at how much income is related to franchise fees compared to recurring royalty income.

  5. Corporate parent pays more attention to supply chain and discounts to increase revenue, again usually a signal of declining recurring royalties. Unclear disclosures about rebates and supply chain costs to franchisees should also encourage you to move on to other concepts.

  6. Inflated sold not open (SNO) funnel or SNO numbers that are set are adjusted from year to year due to weak unit openings. Google press releases and industry articles from previous years. Boast the management of “400 units sold” five years ago, but only 50 units are open, and the rest are still on the list of items 20 sold not open? Red flag.

  7. A growing number of underperforming franchises. Again, it’s worth the time to track down old releases so you can compare years of device-level performance. How resilient is the concept? Are trends positive?

  8. The franchise ceases to publish earnings representations for Item 19 when Item 19 was routinely included in prior disclosures.

  9. Increased litigation from franchisees

  10. Franchisees who want to sell before the end of their first license agreement.

  11. Prospective franchisees exit after considering resale options.

  12. Franchise discontent spills over into websites dedicated to publishing stories from unhappy franchisees.

  13. During the validation, you discover that the franchisees are not following the system. They have developed “hacks” to improve profitability.

  14. Poor franchisee validation, poor franchisee surveys or other signals of a dysfunctional franchisee-franchisor relationship.

  15. Shrinking candidate funnel

  16. Impairment of customer interest; falling market share.

  17. Corporate team turnover, especially among field support (they are the employees who work most closely with potentially unhappy franchisees). Do franchisees rate the management team’s performance positively?

  18. Do you see danger signs but management seems to be in denial? Complacent? To blame the franchisees? Has anyone from the corporate team ever set out to become a franchisee themselves? Why not?

  19. Is there evidence of ongoing investment in innovation to keep the brand relevant? Are the franchisees saying this is a problem area?

  20. Relatively high Small Business Administration (SBA) loan costs. These are lagging indicators due to time, but certainly a disturbing signal.

Related: What You Really Need to Look for When Considering a Franchise

Does working through the above list work? You can bet on that! You owe it to yourself to carry out thorough due diligence. The list above will save you time, money and headaches. If you see weak signals, don’t waste your time. Just continue. There are many strong, healthy, proven franchise options out there. Be picky and protective of your time and money. Only the most worthy concepts deserve your attention and commitment.

What if you are a franchisor and recognize troubling signals from your own brand in this list? Start by improving the financials at the unit level and rebuild trust and strong communication with the franchisees. These are the two areas of greatest impact in any franchise.

Are you interested in selling your franchise business to private equity? Preventing problems in the first place is key. Any hint of trouble can have a major impact on your deal terms, business value, and even which investors will take a serious interest in your brand. Once you’ve stopped, the bar is raised to prove you’re back on track. Remember that most PE investors in franchising want a growth story, not a turnaround project. Are you building a valuable reputation?

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