Is franchising right for you?

Q: Is franchising right for me?

There are three main ways to get into business: start from scratch, buy an existing business or purchase a franchise.

Franchising is a well-established method of doing business in which the franchisor (the seller) allows the franchisee (the buyer) to use its trademark, trade name and very often its business system in exchange for a fee (usually a franchise fee and royalties from sales). There are three key issues that a true franchise offering must contain.

  • Use of the franchisor’s trademark and trade name.
  • Payment of $500 or more during the first six months of operation.
  • Provision of assistance and training and/or control of the franchisee.

franchise agreeementPurchasing a franchise can be beguiling. After all, you’re getting a proven product backed by a proven business model, processes and procedures, with built-in marketing and loyal clientele.

Or are you?

An oft-repeated statistic is that less than 5 percent of franchised businesses have been discontinued since 1985.

This stat is based on a real 1990s U.S. Department of Commerce report, since thoroughly debunked but still used by questionable businesses. Franchising is regulated for a reason — it continues to suffer high rates of misrepresentation and fraud. Studies vary enormously, but some show franchisees’ first year failure rate is the same or higher than other businesses, up to 80 percent; and that about 65 percent of franchises survived after four years, compared to more than 70 percent of independent businesses. Retail franchises fared even worse.

To assess your fitness for franchise ownership, ask yourself a few simple questions.

  • Can I accept guidance and direction, or do I prefer to chart my own course?
  • Can I give total commitment to a product or service not of my own design, and which may have serious flaws?
  • Can I accept that part of my profits must be paid to the franchiser?
  • Will I resent having to send information on sales and other documents from my business to the franchiser?
  • How will I feel about the franchiser’s representative visiting me to check on the quality of my product or service?
  • Am I proficient at following operations manuals and implementing prescribed processes?
  • Can I accept that my franchise ownership may be for a fixed term, with an option to renew for an additional fixed term?

Experience matters

Franchisors prefer that owners have some previous experience, and usually require the new owner to undergo training on the franchise way of operating. This training is usually at the owner’s expense; understood that clearly before the purchase. In some cases, the franchisor will require some work experience in their system before a buyer can qualify to own a franchise.

One group of entrepreneurs who appear to enjoy great success with franchising are veterans. That may be because of their high comfort level with following established procedures, using detailed operating manuals and a chain of command. In fact, because of this tendency toward success for veteran business owners, some franchises offer startup and licensing discounts for former members of the armed services.

Taxes, regulation

Check each state in which you plan to operate for requirements to pay income tax. In Missouri, check “Regulations, legal & taxes” and the Missouri Department of Revenue.

Franchisers must comply with Federal Trade Commission rules. Some states also regulate franchising; Missouri is not one of them. Every franchiser must provide potential franchisees with a franchise disclosure document (FDD), however, which must contain extensive information about the company. A prospective franchisee must also receive the franchisor’s FDD at least 14 days before being asked to sign any contract or pay any money to the franchisor.

All franchise buyers should use information contained in the FDD in franchise research.

Advantages and disadvantages

In return for franchise fees, you will receive access to the franchiser’s experience and expertise. You’ll get training in how to run the business, the company’s brand name, promotional and advertising support and detailed instruction on how to make your business run profitably. If the franchiser does his job, you will receive lots of support, not only at startup, but throughout your tenure with the business.

Other advantages include an established brand and customer base. You’ll have reputable suppliers of materials and realize some economies of scale when purchasing. Some franchisors supply financial assistance to franchisees, and you benefit from ongoing research and product development.

There are some disadvantages to franchising, however. Not being able to entirely run your own show is certainly one of them. In addition, some franchisors require you to pay for marketing assistance in addition to a franchise royalty fee. You have limited creativity and flexibility in implementing the business model. In large measure, you are tied to the success and reputation of the franchisor.

And franchising is not without financial risk. Just because a franchise is popular in one community, region or state does not mean that it will necessarily be successful in your community. Franchises that cater to a passing fad can be just as tenuous as any other type of business.

Any franchise or business opportunity offering should be investigated thoroughly before a contract is signed. Danger signs include inflated promises of large returns on a small investment and sales tactics that pressure you to act immediately. If it appears the franchisor primarily makes money from an up-front sales fee with no care about whether the franchise is a success, act with considerable caution.

How to evaluate a franchise

The first step is to do your research. Franchise fees vary widely by industry and by franchise. Likewise, the amount of vetting of the concept and success factors can vary widely. If the franchiser is under-funded to start with, if the idea is ill-conceived or has not been adequately tested and if the franchiser does not provide adequate training and mentoring, no matter how hard you work or how enthusiastic you are, your chances for success are small.

The average franchise investment is about $254,000, excluding real estate. The average royalty fees paid to the franchisor range from 3 to 6 percent of monthly gross sales. The average length of a franchise contract is 10 years. Are you prepared for that level of commitment?

You should thoroughly understand the terms of an FDD, or franchise agreement. Though many franchisers are reputable, some depend on emotion and pressure sales rather than reputation and referrals. Some business offerings encourage you to “Sign up before this once in a lifetime opportunity is lost!” These so-called opportunities are typically presented in a seminar and offer a special price if you sign up quickly before the “discounted” price of the opportunity expires. After this upfront fee is paid, merchandise to run the business is sold at inflated prices. Long-term support is rarely provided. This age-old fraudulent formula is used with alterations for many different types of products or services.

There are three critical ways to evaluate a franchise offering:

  • Obtain and read the legal documents provided by the franchisor
  • Interview current franchisees
  • Engage an attorney with experience in franchise law.

Once you have identified possible franchise opportunities that appeal to you and which you think you can afford, speak with current franchisees to get the real scoop on owning the franchise. What are the earnings, and what are the costs? What kind of support does the franchisor provide? Do the earnings live up to expectations? Is the franchisor a support or a pest? If they had it to do over again, would they choose the same franchise? Would they choose a franchise at all?

Consider the following questions to ask other franchise owners:

  • How well does the product/service sell? How strong is customer demand?
  • What level of service does the franchisor provide?
  • How do your customers feel about the prices?
  • Are there any operating methods do you dislike?
  • Was the training and assistance adequate?
  • How good is the location of your business? Did the franchisor help with the selection of the location?
  • How solid is the franchisor’s reputation?
  • How long did it take you to break even?
  • Would you buy this franchise again?
  • Did you negotiate any aspects of the franchise agreement?
  • What can I expect for my first year sales?
  • Does the franchisor provide adequate marketing support?
  • How often does the franchisor update the product line? Does the product line stay current with your local market demand?

Consider the following questions to ask the franchisor:

  • Do patents, copyrights, trademarks or service marks protect the product?
  • Do you have an exclusive territory? Do I have the first right of refusal for new franchises in my territory?
  • What is the planned rate of growth for new franchises in my territory?
  • How many outlets are company-owned?
  • Have any franchisees failed? Why?
  • Can the franchise be transferred to another owner? What does this require?

Why use a franchise law attorney?

The franchiser has an attorney to protect the company’s interests. And you need an attorney to protect your interests.

It is critical that the attorney inform you of all of the crucial issues before signing a contract that will be binding for five, 10, 15, even 20 years. An attorney who specializes in franchise law will have a clear understanding of both federal and state regulations.

Have your attorney carefully review the FDD. Ask your attorney for referrals to accountants who specialize in franchises, then select one to review the franchisor’s audited financial condition. If the franchisor goes out of business, what would happen to your franchise?

Financing

Since franchises usually have a proven track record of operations, they can provide more accurate information for a business plan. The combination of a reliable business plan and proven track record can make it easier to finance a franchise through traditional financing. Understand clearly what fees are required in the purchase of a franchise.

The SBA has a franchise registry that streamlines the process to obtain a SBA loan from more than 5,000 lenders.

Most franchises — especially entire business system franchises — require monetary contributions by franchisees consisting of some or all of the following:

  • An initial franchise or license fee
  • Training costs (tuition, room and board, transportation)
  • On site startup aid and promotion charges (some or all of which may be included in the initial franchise or license fee or may in whole or in part be separately stated)
  • Periodic royalties or service fees and an advertising contribution (usually payable monthly or weekly and based on a specified percentage of sales).

There may also be charges for centralized bookkeeping, accounting and data processing services. There may also be initial payments for premises, equipment, supplies and opening inventory, if acquired from franchisor. (If acquired from other approved sources, the payment for them is nonetheless part of your initial opening cost.) Get specific details on all cost items: amount, time of payment, financing arrangements.

Terms like “initial cost,” “initial fee,” “total cost” and “royalties” should be specifically defined and crystal clear to you. The terms “cash required,” “initial cash required,” “investment,” “down payment” and “equity investment” can mean different things in different offerings.

Make certain your investigation and your understanding complete in the following areas:

Initial license fee

“Initial fees” probably do not include any equipment or product inventory down payment.

Is there one? How much is the total fee? Is it payable in a lump sum or in installments? If in installments, with or without interest? Is it refundable? Is it non-recurring? If the initial license fees are not the same for each franchise concurrently granted, on what factors are the differences based? Does an initial license fee include compensation in full for the current operation manual, training and startup aid, including personal, on site and promotional assistance? It does not in many cases. The contract should be explicit.

Continuing regular fees

Are there periodic royalties? How much are they? How are they determined?

In business format franchising, generally, there is a periodic royalty (usually payable monthly or weekly), commonly based on a percentage of sales. How and when are sales and royalties reported and royalties paid? Royalties are not only payment for use of a trademark and trade name (and, where available and applicable, other commercial symbols, patents or formulas) but may also constitute a fee for services to be performed by franchisors. If the periodic payment is in part a service fee, what ongoing services are you to receive from the franchisor? Are accounting services included or available? Are they computerized? Will updated merchandising services, operating manuals and training be furnished without additional, or at nominal, cost?

Other fees

What other fees and charges, if any, are payable (for example, advertising and promotion)?

Total costs

In determining total opening costs don’t overlook working capital and rent, inventory, payroll, insurance and your own promotions and salary the first year. Know what your monthly debt service will be under deferred payments financing. Do not confuse “initial fees,” “initial cash required,” “initial investment” or “initial costs” with total costs. Initial cost or initial investment may require computation and inclusion of initial franchise fees, license fees and royalties.

Also, are you required to purchase or rent business premises? Who finds the site? What is its cost to you as purchaser or lessor? How is it to be financed, if purchased? Does “initial” cost or investment include an “opening” inventory of products and supplies; a down payment on equipment and fixtures; a lease security payment; or all or part of the franchise fee? What amount is attributable to each such item? Don’t confuse down payment or initial cost with ultimate cost, either.

What are deferred balances, who finances them and at what rate of interest? If the franchisor doesn’t, do they offer help in finding financing? Have you received a commitment for financing before committing yourself? Can you seek competitive financing sources, or is use of the franchisor or its designated source mandatory? (It should not be.)

What, if any, are construction, remodeling and decorating costs, security deposits, if any, and initial equipment and inventory requirements costs? In determining total costs, check every aspect of the deal. Do not overlook the cost of finding, buying or leasing, improving and equipping a business location and obtaining zoning licenses for the operation and the financing costs involved.

Portions of this story were previously featured in prior Missouri Business eNewsletters.

Appendix

There are an estimated 15,000 franchises available in the United States. Reputable websites, publications and organizations that track and list franchises include:

Be wary of any website, publication, expo, lender or service that sounds too good to be true. It probably is. 

* Entrepreneur 2014 Franchise 500’s top 10 franchises with startup costs:

  1. Anytime Fitness $56.29K – 353.89K
  2. Hampton Hotels $3.69M – 6.57M
  3. Subway $85.69K – 262.85K
  4. Supercuts $113.75K – 233.6K
  5. Jimmy John’s Gourmet Sandwiches $330.5K – 519.5K
  6. 7-Eleven Inc. $50K – 1.63M
  7. Servpro $138.55K – 187.19K
  8. Denny’s Inc. $1.12M – 2.61M
  9. Pizza Hut Inc. $297K – 2.1M
  10. Dunkin’ Donuts $249K-1.5 M