In 2013, a New Jersey franchisor collected more than $5 million from recruits in exchange for a liability insurance fee 20 times the market premium. On the basis of a tiny swath of fine print, dreams of wealth and financial freedom were obliterated. Surprisingly, this kind of ethical breach is more common than you might think. Franchise fraud strips US franchisees of an estimated $500 million a year, and it’s notoriously difficult to spot.
In 2008, the Securities and Exchange Commission filed fraud charges against Bally Total Fitness for including over 24 accounting inaccuracies in its financial statements. Its heavily overstated equity threw up an easy-to-spot red flag: a list of bankruptcy filings long enough to terrify. Breach of exclusivity is another common misrepresentation. If your franchisor offers you exclusive command of your territory, it’s required to hold to that promise.
Franchisees are often advised to interview existing recruits before signing their financial disclosure documents, and this is precisely why. Misleading claims are one of the leading causes of franchise fraud. Franchisors are required to disclose their financial data by law, so if a brand hesitates to hand over a comprehensive franchise disclosure document, be on your guard.
Inadequate Franchisee History
The FTC requires franchisors to give you a defined list of key historical data, including their litigation history. There is no easy path through franchising, so if a franchisor is selling you a get-rich-quick scheme, be wary. Even brand behemoths have failure rates based on poor location choices, rising costs, and public relations crises. Artificial failure rates are easy to build out of repurchased units, so it’s important to move beyond your disclosure document by doing independent research.
Franchisors are required to give prospects a two-week disclosure period for signing their documents. Rushed decisions are unconsidered decisions, so a tight deadline is an easy way to draw eyes away from missing information. The 14-day lag gives you time to hire a legal expert to comb through your agreement in depth. Twelve U.S. states also require franchisors to formally register their brands, offering an extra layer of security.
If your franchisor sends you to existing franchisees for more information, be suspicious. The practice might look like transparency, but those recruits are often paid to spin a fraudulent tale of grand success. Due diligence is only diligent if you do your own research.
In 2014, six Bristol franchisors were found guilty of operating a pyramid scheme that cost recruits thousands of pounds. Closer to home, the FTC recently banned a Kentucky pyramid scheme for stealing $7.75 million from franchisees. Chain referral is one of the oldest fraudulent practices in the book, but it shows no sign of slowing down. In the franchise industry, the practice is known as “churning” and often involves the resale of failed franchises to new recruits. It can also take the form of a classic pyramid scheme that rewards recruits every time a new franchisee is brought on board. If a franchisor isn’t rewarding you for selling or offering a service, you might be dealing with a chain referral scheme.
An FTC survey found that only 69% of franchisees use their disclosure documents for anything beyond lining their cupboards. This humble piece of paperwork is the most reliable way of avoiding franchise fraud, but you can only unlock its powers if you read it. There’s another red flag that’s even easier to spot: claims of risk-free trade.
There’s no such thing as a perfect business opportunity, so the promise of one is often deceptive.