3 Companies Franchisees Should Be Cautious Of

NEW YORK ( MainStreet) -- Choosing to invest in a franchise means figuring out which systems hit on several key areas, including strong management, good unit economics and brand awareness. Of course, not every franchise rates the same. While some franchises are worth two thumbs up, others should indicate a note of caution when investing in them.

The Great Recession has definitely put its mark on more than one franchise chain, leaving many current franchisees to deal with the problems of their parent company. With credit access open prior to the recession, franchisors pushed rapid expansions, but some did less than their share of due diligence on who was investing -- and running -- stores.

There are plenty of warning signs that a parent company may not be ready to take on more franchise stores, such as fewer new stores opened (including ones indefinitely "under construction"), slower supply deliveries and a pullback on national advertising.

A potential franchisee might not notice some of the warning signs. So to start, a Google ( GOOG) search should set you on your way to find out information about the franchise. If a franchise has legal problems, for instance, which should be a major deterrent, you can probably find that out simply by checking the Web.

More formally, companies are also required to give potential franchisees a Franchise Disclosure Document, or FDD. Not only does the federally-required prospectus hold information on the actual terms of your franchise agreement, but the FDD will give you a reasonable look-through into the company in typical areas such as company history, financials, ongoing litigation as well as background information about existing franchisees, including numbers on whether the system is growing or contracting.

Steve Olson, president of Franchise Media Update Group, says if franchisors put any information under Item 19 of the FDD, that's a good sign, since they aren't required to fill out that section. This is the area where franchisors can disclose earnings details, expenses and factors that might affect future financial performance.

Experts agree that it is imperative for potential franchisees to talk to and visit with multiple current franchisees.

Paul Segreto, president and CEO of franchisEssentials, says ongoing litigation, problems with unit economics, saturation within markets or a lack of catering to ever-changing consumer trends, should make prospective franchisees think twice before invsting in a company.

He also warns against getting into franchises that cater to fad menu items, such as cupcakes or yogurt - two niche areas where he expects a shake-out.

Additionally, when it comes to location choices, franchisees should not try to settle either. When looking at your local market, make sure you are investing in the ideal location (many established franchises will send out staff to choose a good location) because "foot traffic is absolutely paramount," Segreto says.

"If you can't find a location right for that brand look at something else. Too often new franchisees take the secondary location because they think the brand is strong enough," he says. "The brand is never strong enough for a secondary location."

Of course, there is no guarantee that a company that does everything right is sure to succeed, just as a company that has legal problems or issues with unit economics is not sure to fail. However, given the current issues surrounding the following three companies, potential franchisees should proceed with caution.

1. Quiznos
Denver

Quiznos is just starting to break free from its troubles, thanks to a debt restructuring program and equity capital injection the company announced in late January. The chain of sandwich shops, known for its toasted subs, suffered several years of declining sales, store closings, upset franchisees and accumulating debt, according to media reports.

Quiznos had been trying to avoid bankruptcy by negotiating with its creditors, store landlords and others. The company ended up handing over majority ownership to hedge fund Avenue Capital Group in January.

The company has just about 2,900 locations, primarily in the U.S., but also internationally. That's down significantly from the 5,100 locations the company boasted in 2006, a January Nation's Restaurant News article says.

According to a QSR Magazine story, the sandwich chain had embraced rapid expansion (and focused less on operations), which ultimately led to debt problems.

"Improving our balance sheet and putting our capital structure issues behind us are major steps forward to strengthening the Quiznos brand and our customer experience," Quizno's CEO Greg MacDonald said in the January announcement.

The $150 million cash injection from Avenue Capital will help the company launch a consumer marketing campaign, invest in system analytics and improve operations, it said in January.

The company is now working towards improving the brand, expanding selectively and eventually rolling out a new menu. It is also instilling several quick-service and fast-casual veterans as new additions to its board of directors. In February, industry veteran Harsha Agadi, who most recently served as the chairman and CEO at Friendly's Ice Cream, was named Quiznos' executive chairman.

By January 2013, Quiznos hopes to open 100 traditional outlets and 150 non-traditional locations, according to the QSR story.

The company is also building a new prototype store, with updated décor and lower build-out expenses. Its first one opened in Portland, Ore., according to Nation's Restaurant News.

Segreto says while the company has made progress, noting the January settlement, he suggests potential franchisees wait to see how the restructuring and reboot pans out before buying into the company.

Quiznos' new management and ownership team has positioned the company for long-term growth, CEO Greg MacDonald says, while the new equity capital will "continue to position Quiznos as an attractive franchise investment opportunity."

"Today's Quiznos is stronger than ever before and we are resolute in our focus of further building the Quiznos brand and customer experience," MacDonald said in a statement Thursday.

2. Curves
Woodway, Texas

Fitness club franchise, Curves , is another company that went through rapid expansion - until it began to oversaturate its markets.

The idea behind the company, a female-centric fitness club that also offers diet and nutrition programs was a fine one, but some franchisees say the company was more concerned about its growth plans than doing due diligence on potential franchisees and properly training existing ones.

Curves has roughly 4,000 locations - a number cut in half from its peak in 2005, according to the The Wall Street Journal .

The company was also resistant to changing the business model as market demographics changed. Between the oversaturation of locations and the economy putting a crimp on consumers' wallets, membership was falling.

Curves didn't embrace the round-the-clock access for members without supervision that many other fitness chains implemented. Founder Gary Heavin argued that having locations open 24/7 didn't fit with the company's strategy. "Curves is about providing a supportive environment for women, and an empty room filled with machines in the night is not my idea of a supportive environment," he told the WSJ in the August article.

But the company is reinventing itself with "a new weight-loss program, improved training for franchisees and their staffs, and an online 'university' to teach nutrition and more," the article said.

In December, the company launched Curves Complete, a weight-loss program that combines "diet, exercise and motivation," according to the press release.

Curves' troubling unit economics is what concerns Segreto. "They oversaturated the market. There are a lot of stores closing. They've got a very unfavorable non-compete and termination clause and a lot of legal issues. Even if a franchisee has lost their money and closed their doors," they are still liable for financial issues that can't be negotiated, Segreto says.

Curves representatives did not respond to requests for comment.

3. Cold Stone Creamery
Scottsdale, Ariz.

Litigation is what is plaguing Cold Stone Creamery , the premium ice cream chain bought by Kahala in 2007.

According to the Cold Stone Creamery website, the company has 1,500 franchises in 20 countries.

Doing a simple Google search on "Cold Stone Creamery" and "franchisees" pulled up the website, Unhappy Franchisee , which doesn't exactly paint Cold Stone or Kahala in a positive light.

Like the other two companies on this list, Cold Stone was also subject to an extremely rapid expansion right before a downturn. Many franchisees have closed over the years due to high operations costs and a recession in which consumers tightened the purse strings. Add in the fro-yo craze and a general transition toward healthy eating and the growth prospects don't look as exciting for Cold Stone Creamery.

Further, Cold Stone and franchisees threatened legal action against CNBC in 2010 for purportedly portraying the company in a negative light in a segment on franchising. According to Blue MauMau , the segment accused Cold Stone of hiding expenses and relying on kickbacks from vendors while requiring franchisees to purchase equipment from them, the article says.

A lawsuit filed in January on behalf of a group of Cold Stone franchisees under the National Association of Cold Stone Creamery Franchisees, is seeking to get more information on the matter.

The lawsuit suggests that the company failed to disclose how the money rebated by vendors is used and whether prices of purchased products are raised in order to offset the rebates to the parent company, according to QSR Magazine . The group also wants the company to disclose financials related to gift card sales and whether money from unredeemed cards is retained or used by Cold Stone, the article says.

Experts say that legal matters are one of the biggest detractors to potential franchisees. It's no telling how long the lawsuits will last and what the final outcomes will be.

The company did not return a request for comment.

-- Written by Laurie Kulikowski in New York.

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