Explanation

The franchisor's audited financial statements show decreasing revenue from 2023 to 2024 and a relatively small net income. The balance sheet also indicates significant loans to and from related parties and members, suggesting complex inter-company finances. While profitable, the declining revenue and thin margins could impact the ability of Flip Flop Shops, LLC (FFS) to invest in the system and support franchisees long-term, especially given the high franchisee turnover noted in Item 20.

Potential Mitigations

• A franchise accountant should conduct a detailed review of the audited financial statements, including all notes, to assess the company's financial stability and cash flow.
• Discuss the decreasing revenue trend and the nature of the related-party loans with your accountant to understand their potential impact on the business.
• It is wise to ask the franchisor about their strategies for reversing the revenue decline and supporting the system's growth.

Explanation

Item 20 data reveals a significant and concerning rate of franchisee turnover. In the last two years (2023 and 2024), a total of 26 franchised outlets "Ceased Operations - Other Reasons" out of a system that started 2023 with 56 units. This high rate of unit closures is a critical red flag, potentially indicating systemic issues such as franchisee unprofitability, dissatisfaction with the business model, or insufficient franchisor support.

Potential Mitigations

• Your attorney can help you formulate pointed questions for the franchisor about the specific reasons for this high number of closures.
• Contacting a significant number of former franchisees from the list in Exhibit D is crucial to understand why they left the system.
• A business advisor should help you weigh the risk of failure indicated by this data against any potential rewards.

Explanation

FFS was formed in 2018 after acquiring assets from a predecessor, giving it a relatively short operating history under current ownership. This brief history is combined with significant red flags, including a government enforcement action for illegal franchise sales, litigation against the predecessor for fraud, and a very high rate of franchisee closures shown in Item 20. This combination suggests a system that may still be facing significant operational and viability challenges.

Potential Mitigations

• A thorough due diligence investigation with your business advisor is critical to evaluate the viability of this business model given its history.
• Your attorney should help you understand the implications of the past litigation and high turnover on your potential success.
• Speaking with the longest-operating franchisees under the current ownership is essential to gauge the system's stability and support.

Explanation

While the management team has experience in the footwear industry, their history is concerning. The current franchisor entity, FFS, has a history of regulatory non-compliance, having been fined for selling franchises illegally in California. Furthermore, the CEO was subject to a multi-million dollar judgment for patent infringement and unfair competition in a prior business. This history could raise questions about the management's approach to legal compliance and business practices.

Potential Mitigations

• A discussion with your attorney is crucial to understand the potential risks associated with the management's litigation and regulatory history.
• Speaking with current franchisees about their direct experiences with the management team's competence and support is highly recommended.
• A business advisor can help you assess whether the management team's industry experience outweighs the risks presented by their legal history.

Explanation

The franchisor, FFS, is the successor to Flip Flop Shops Franchise Company. Item 3 discloses significant and damaging litigation against this predecessor, including a judgment for over $429,000 related to fraudulent inducement and using unlicensed brokers. Furthermore, the current franchisor was sanctioned by California regulators for failing to properly disclose this predecessor's litigation history in prior FDDs. This indicates a troubled history that directly impacts the current system.

Potential Mitigations

• A thorough review of the predecessor's litigation history with your attorney is essential to grasp the inherited risks.
• Questioning the franchisor about the operational changes made since acquiring the system from its troubled predecessor is a necessary step.
• Discussing the system's history with long-term franchisees who operated under the predecessor can provide valuable context.

Explanation

Item 3 discloses a concerning pattern of litigation and regulatory actions. This includes a California government action for selling franchises illegally and failing to disclose material facts, a large judgment against the predecessor for fraudulent inducement, and a multi-million dollar judgment against the CEO for patent infringement. This history suggests significant risks related to the franchisor's compliance, disclosure practices, and management's business conduct, which could negatively affect the entire system.

Potential Mitigations

• A franchise attorney must review the details and implications of all disclosed litigation and regulatory actions.
• This pattern of litigation should be a primary topic of discussion with current and former franchisees to understand its impact on their businesses.
• Your business advisor should help you weigh whether the potential of the franchise opportunity justifies these significant legal and reputational risks.