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For years, you dreamed of being your own boss and now you’re ready to put the 9-to-5 (or 8-to-5) grind behind you and realize your dream. As you think about all that goes into creating a new brand and business plan, you become more than a little apprehensive. Suddenly, striking out on your own doesn’t seem like a good idea.
Before giving up on your dream of business ownership, consider buying a franchise business. With a franchise, you get to be a business owner and have the support of an established brand that offers a proven operations plan.
Buying a franchise enables you to operate a business using a system developed by an established company (franchisor). As the franchisee, you pay a franchise fee for the right to use the franchisor’s name for a specified number of years. The franchise fee may also cover assistance in the form of training, finding a location; and management, marketing or personnel advice.
In exchange for the right to use the franchisor’s name and system, these are the typical costs. Expect to pay some or all of the following.
Depending on the franchisor, your initial franchise fee can range from tens of thousands to several hundred thousand dollars. You may also have to pay to rent, build or equip a location and buy starting inventory. You may have to purchase business licenses and business insurance. To promote your franchise location, the franchisor may charge a “grand opening” fee.
You’ll typically have to pay royalties based on a percentage of your weekly or monthly gross income. It’s not uncommon to be required to pay royalties even if you’re losing money or if the franchisor doesn’t provide the promised assistance; you still have to pay for the right to use the franchisor’s name. If you decide to terminate your franchise agreement early, you may have to pay royalties for the duration of the agreement.
You may have to contribute to an advertising fund where a portion of the fees is used to run national ads.
To protect its brand, franchisors generally insist on uniformity and will also control how franchisees conduct business. These controls may limit your ability to use your own judgment (which was likely the case in your corporate career).
The franchisor may not approve a site that you select. This could work in your favor, however, since franchisors often conduct thorough site studies and a site they approve may be more likely to draw customers.
To ensure a uniform look among franchisees, franchisors may enforce design or appearance standards. Franchisees may also have to pay for periodic renovations if the franchisor decides to change its logo, color scheme, etc.
The franchisor may regulate the goods and services you sell. For example, if you purchase a tax preparation franchise, you may not be allowed to offer bookkeeping services. If you purchase a cupcake franchise, you may not be allowed to add cookies to your offerings.
Franchisors can insist that you operate in a particular manner. They may require approval for hours of operation, signs, employee uniforms, advertisements, and accounting procedures. Your profit margins can be adversely affected if a franchise advertising cooperative requires you to sell goods or services at a discount, or if you’re required to buy supplies from an approved supplier.
To protect all of its franchisees, a franchisor may limit your business to a specific location or sales territory. The franchisor and other franchisees may be prevented from opening competing locations or serving customers in your territory, but the franchisor may still have the right to offer the same goods in your territory via its website, catalogs, or other competing company-owned franchises. For example, a franchisor offers Happy Burger and Wonder Burger franchises. If you purchase a Happy Burger franchise, the franchisor and other franchisees may be prevented from opening other Happy Burger franchises in your territory but the franchisor may still have the right to open a Wonder Burger in your territory.
If you don’t comply with the terms of the franchise agreement, you could lose the right to operate your franchise. A franchise agreement is only valid for a specified number of years and you can only renew the contract if the franchisor grants that right.
There are a number of reasons that a franchisor will end your franchise agreement including not complying with performance standards, not paying royalties and selling goods or services that the franchisor prohibits. You may be given the opportunity to remedy the situation but the franchisor reserves the right to terminate your franchise agreement if there are other instances of non-compliance. You’ll likely lose all monies invested if your agreement is terminated.
Though some may last for up to 20 years, franchise agreement renewals aren’t automatic. At the end of the agreement term, the franchisor may refuse to renew the agreement or change the terms and conditions. The renewal agreement could include higher royalty payments, a change in design standards, more goods and services that you can’t sell, or a reduction in your sales territory. These changes could result in higher costs, lower profits, and more competition from the franchisor or other franchisees.
There’s an obvious reason for would-be entrepreneurs’ interest in the franchise business model. Starting a brand new business with its inherent uncertainties can be intimidating. A franchise, on the other hand, offers name recognition, a support system, and a proven method of conducting business.
If you’re contemplating buying a franchise, don’t expect success to happen with little effort on your part. Yes, a franchise business offers a tried-and-true system that has generally worked for many franchisees. But, that doesn’t mean buying a franchise equals quick and continued success. Running a franchise is still hard work and although you’ll realize your dream of being a business owner, you won’t necessarily be your own boss.
To determine if this business model is right for you, let’s take a look at the pros and cons.
Whether you have a particular franchise in mind or have yet to research the vast number of franchise opportunities available, the following benefits are typically offered.
When you’re just starting out, getting customers to take a chance on you can be challenging. With a franchise, customers are more willing to do business with you because they recognize the brand name. They know that the Big Mac from your McDonald’s franchise is going to taste just as yummy as the ones they’ve purchased from other McDonald’s franchisees.
Because the franchisor’s system has been tested and proven to work, you get to skip many steps in the startup stage. You don’t have to create and test a product, write a business plan, or conduct market research. You just have to apply the system to your sales territory.
Franchises are successful because the franchisor has created a system that’s easy to replicate. You’ll get help training employees in that particular franchisor’s method of operation. On-site training on everything from using point-of-sale software to store opening procedures is often provided.
As a franchisee, you’ll benefit from national advertising campaigns that the franchisor runs on TV, radio, and online. You may also receive assistance from the franchisor to create and effectively execute your own campaigns. A marketing plan which includes market analysis, sales forecast, and budget may also be provided.
You’ll get to enjoy a benefit that large companies have enjoyed for years – increased purchasing power. The franchisor may purchase large quantities of inventory and equipment on behalf of its franchisees, which will reduce your cost.
Franchises can come with a hefty price tag. The franchise fees can be in the hundreds of thousands of dollars. There are less expensive franchises but, when you consider other startup expenses, some prospective franchisees may still need to obtain financing.
Securing financing for a new business is always challenging. The Small Business Administration (SBA) offers several programs to help business owners obtain needed financing and although their qualification requirements are somewhat stringent, it may be easier to qualify if you’re seeking financing for a franchise as opposed to starting a business on your own. The SBA reserves a portion of their total loan allotment especially for franchises.
The two best SBA loan options for franchises are the SBA 7(a) loan and the SBA CDC/504 loan. Check the SBA Franchise Directory to see if the franchise you’re considering is among those that the SBA has reviewed as eligible for financial assistance.
Even considering the above benefits, a franchise isn’t a perfect business model. If you decide to proceed with buying a franchise, know that there are issues you’ll have to face. It’s important to know what they are before signing a franchise agreement.
Again, the costs involved in buying a franchise can be rather steep and inflexible. Unlike in starting your own business, you can’t forego, postpone, or reduce certain startup costs. As a franchisee, you must abide by the terms of the franchise agreement and invest the amount dictated by the franchisor.
Most business owners start companies to be their own boss. If you purchase a franchise, that won’t be the case. Yes, you’ll technically own your franchise but you’ll be required to follow the franchisor’s rules, regulations, and method of operation. You may have some autonomy but for the most part, the franchisor runs the show. If you find a more efficient and/or cost-effective way to operate your franchise, you won’t be able to implement it if the franchisor doesn’t approve.
If the franchisor is involved in a scandal or if another franchisee gets bad publicity, this could affect your business. Customers may associate any bad press with the brand in general and shun all locations bearing the brand name. This isn’t fair to franchisees with well-run, scandal-free locations but unfortunately, it could happen.
If the high startup costs weren’t enough to give you pause, you’ll have to make ongoing royalty payments to the franchisor for the use of its name and system. You’ll likely have to contribute to a marketing and advertising fund and a portion may be used to recruit new franchisees.
As part of the process of buying a franchise, you’ll have to sign a franchise agreement that details what’s expected of you as a franchisee. Not abiding by the rules and regulations set forth in the agreement could cost you your franchise. If you decide to end your relationship with the franchisor, you’ll find that the terms could make this rather difficult.
Don’t invest in any franchise system without receiving a copy of the franchisor’s Franchise Disclosure Document (FDD). According to the Federal Trade Commission’s (FTC) Franchise Rule, the franchisor must provide this document at least 14 days before you’re asked to sign any agreements or pay any fees. Once the franchisor has received your application and agreed to consider it, you’re entitled to request a copy of the FDD. The cover of the FDD must list all available formats (i.e. print, email, web page, or disc) so that you can receive the format that’s most convenient for you.
There are 23 numbered items in the FDD. Read each item carefully and ask for clarification if necessary. Here’s an overview of the key items:
Item 1 tells how long the franchisor has been in business and who likely competitors are. It also lists any legal requirements like special licenses or permits. This information lets you know the costs and risks associated with buying the franchise.
Item 2 lists executives of the franchisor and provides information on their general business background, experience managing a franchise system, and how long they’ve been with the franchisor.
Item 3 lets you know if there’s been prior litigation involving the franchisor or any of its executive officers. This section will also let you know if franchisees were dissatisfied with the franchisor’s performance such that they sought legal recourse.
Item 4 discloses whether the franchisor, its affiliates, or any of its executives have been involved in a recent bankruptcy. If so, the franchisor may not be financially able to deliver the support services it promises.
These items describe some of the costs involved in starting and operating the franchise, including deposits and franchise fees which may be non-refundable. Costs for initial inventory, signage, equipment, and leases as well as ongoing costs like royalties and advertising fees will be disclosed.
If not listed, ask about other costs such as leasehold improvements, required equipment, and employee salaries. Accounting or legal assistance costs likely won’t be included, so you’ll need to find this out on your own.
Use the Information in the FDD and from your own research to estimate your operating expenses for the first year. Compare your cost estimates for this franchisor with those of a competing franchisor. The other franchisor may offer a system that’s more profitable.
Items 8 and 12 tell you whether the franchisor controls:
If the franchisor doesn’t limit the territory where the franchisor and each franchisee can sell, you could find yourself competing for the same customers.
Item 11 summarizes the franchisor’s advertising programs and the initial and ongoing training that will be provided.
If franchisees are required to contribute a percentage of sales to national, regional, or local advertising funds, ask the franchisor:
To successfully operate a franchise, new franchisees count on the franchisor to provide training on their system. Item 11 should provide information about:
Item 17 covers the following topics:
The Franchise Rule doesn’t require franchisors to provide franchisee sales or earnings information in the FDD. However, most franchisors still provide this information in Item 19.
All financial performance claims must be included in Item 19 unless:
Item 20 provides information (in chart form) on growth and owner turnover. If you see that several franchise locations in your area have closed, been taken over by new owners, or transferred back to the franchisor; this could indicate that the franchise isn’t profitable or there are problems with the franchisor’s support.
Current and Former Franchisees
Contact information for current franchisees and those who ended their franchises within the last fiscal year must be disclosed in the FDD.
Exercise caution when considering a franchise location that the franchisor bought back. Ask to see the financials. The franchisor is required to disclose the owners for the last five years. If the location has had several owners in a short time, maybe it’s not a profitable location. Contact the previous owners to get the full picture.
In the FDD, franchisors are required to list associations they sponsor or endorse as well as independent associations. These associations can provide invaluable information about the relationship between the franchisor and its franchisees including any problems franchisees face operating their businesses.
You may want to hire an accountant to interpret the information contained in Item 21. Here you’ll find the franchisor’s three most recent audited annual financial statements. These statements will give you an idea of the franchisor’s financial health.
To minimize risk, you want to invest in a franchise system that (1) shows steady growth, (2) earns most of its income from royalty payments instead of from selling franchises, and (3) devotes adequate resources to support its franchisees.
As a prospective franchisee, you want to know how much money you can make if you invest in a particular franchise. Although the FTC doesn’t require franchisors to disclose this information, most do so in Item 19 of the FDD. If the franchisor discloses sales or earnings information, they are required to have a reasonable basis for the claim which includes (1) the source and limitations of data that support the claim and (2) any key assumptions on which the claim is based.
If asked, the franchisor is required to provide written substantiation that supports the claim. Your accountant can help you assess the validity of the claim, and if it’s relevant based on how you plan to run your business.
When evaluating a franchisor’s earnings claim, you’ll want to consider:
Before signing contracts and investing in a franchise system, be honest with yourself. Does the franchise align with your goals, skills, and available finances? You don’t want to overextend yourself financially or buy into a system that requires a skill set that you don’t possess. Ask yourself the following questions to determine if the franchise model will work for you.
Although a franchise business offers many benefits including guidance and a proven system, success isn’t guaranteed. You’ll still have to put in hard work and have a passion for the business. You’ll also have to be comfortable with abiding by the franchisor’s rules.
If you’ve found a franchise opportunity that checks off all of your boxes, do your due diligence. Carefully review the FDD and franchise agreement before opening your checkbook.
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