Buying a Franchise Business: The Definitive Guide

October 9, 2019
Posted in: Uncategorized

Table of Contents

 

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. 

 

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How Does a Franchise Business Work?

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. 

 

Cost of Buying a Franchise

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.

 

Initial Franchise Fee and Other Costs 

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. 

 

Continuing Royalty Payments 

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.
 

Advertising Fees 

You may have to contribute to an advertising fund where a portion of the fees is used to run national ads. 
 

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Franchisor Controls

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). 

 

Site Approval 

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.

 

Location Design or Appearance 

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. 

 

Goods and Services You Sell 

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.  

 

Method of Operation 

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. 

 

Sales Area 

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.

 

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Contractual Obligations

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. 

 

Terminations 

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. 

 

Renewals 

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. 

 

Pros and Cons of Buying a Franchise Business

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. 

 

Pros of Buying a Franchise Business

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.

 

Name Recognition

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.

 

Proven System

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.

 

Training 

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. 

 

Marketing & Advertising Assistance

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.

 

Increased Purchasing Power

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. 

 

Easier Access to Financing

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.

 

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Cons of Buying a Franchise Business

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. 

 

High Startup Costs 

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.  

 

Following the Franchisor’s Rules

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.  

 

Brand Reputation Issues  

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.  

 

Ongoing Royalty Payments

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.

 

Contractual Agreements

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.

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Franchise Disclosure Document

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: 

 

Franchisor’s Background – Item 1

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. 

 

Business Background of Key Persons – Item 2

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.  

 

Litigation History – Item 3

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.

 

Bankruptcy – Item 4

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.  

 

Initial and Ongoing CostsItems 5-7

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.  
 

laptop

 

Supplier, Territory and Customer Restrictions – Items 8 and 12

Items 8 and 12 tell you whether the franchisor controls:

  • From whom you can purchase inventory and supplies 
  • The goods or services you can sell
  • Where and to whom you can sell goods or services
  • How you use the internet to sell goods or services 
  • Whether the franchisor or other franchisees can use the internet to sell to customers in your territory

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.  

 

Franchisor’s Obligations – Item 11

Item 11 summarizes the franchisor’s advertising programs and the initial and ongoing training that will be provided. 

 

Advertising 

If franchisees are required to contribute a percentage of sales to national, regional, or local advertising funds, ask the franchisor:

  • What advertising it’s done in the past and what’s being planned
  • If franchisees have any control over how advertising dollars are spent
  • The breakdown of the advertising spend – what percentage is spent on administrative costs, advertising in your area, national advertising, and recruiting more franchisees?
  • If franchisees need the franchisor’s consent to develop their own advertising campaigns

 

Training 

To successfully operate a franchise, new franchisees count on the franchisor to provide training on their system.  Item 11 should provide information about: 

  • Qualifications of the trainers
  • Length of training sessions
  • How much time is spent on training in these areas:  technical, business management, and marketing
  • Whether ongoing training and on-site individual assistance is offered and if so, at what cost
  • Who is eligible for training

 

Renewal, Termination, Transfer and Dispute Resolution – Item 17

Item 17 covers the following topics:

  • Whether you can renew your franchise at the end of the term
  • How to qualify for renewal
  • If fees and other contract terms may change upon renewal
  • What your obligations would be to the franchisor after terminating your franchise
  • If you can operate a business that would compete with your terminated franchise
  • If you can operate a business that would compete with other franchise locations
  • How to get the franchisor’s approval to sell your franchise
  • Whether you can go to court over a dispute with the franchisor or must use arbitration

 

Financial Performance Representations – Item 19

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:

  1. The franchisor provides the actual financial records of an existing outlet that you’re considering.
  2. The franchisor provides information about potential performance at a particular location.

 

Franchisee and Franchise System Information – Item 20

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. 

  • Franchisees in business for around a year are the best source of information on training, opening and ongoing assistance, and whether they’ve been able to break even.
  • Franchisees in business for at least five years can tell you how long it took them to break even and recoup their investment. They can also tell you if they’re having problems with the franchisor, the advertising program, or the quality of goods they’re required to buy from franchisor-approved suppliers.  Ask if they’d invest in another franchise location.

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. 

Franchisee Associations 

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.

 

Financial Statements – Item 21

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.

 
taxes

 

Evaluating Potential Earnings

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:

  • If the claim represents the typical earnings of franchisees – The franchisor should disclose how many franchisees it has, how many were surveyed, and the number and percentage of franchisees who reported earnings at the sales or earnings level claimed. 
  • Average income doesn’t reflect individual franchise performance – If a franchisor provides average income, it may make the franchise system look more successful than it is. There may be only a few very successful franchisees that cause the average to be higher. 
  • Gross sales don’t tell the whole story – If a franchisor provides only gross sales figures, you won’t know if a franchisee is making a profit unless you know about their overhead costs. 
  • Net profit figures may not apply to franchisees – If a franchisor provides net profit information, ask if it applies to franchisor-owned locations. Franchisors typically don’t have net profit figures for their franchisees. Franchisor-owned locations will generally have higher net profits because their costs are lower.
  • If the data provided is relevant to your area – Ask if the data that supports sales or earnings figures reflects franchisees in your area. There may be geographic variances and the FDD should state this.
  • Franchisees’ backgrounds – Franchisees with a management or business ownership background may have a shorter learning curve and be more successful than other franchisees.
  • Report disclosed earnings in writing If the franchisor asks you to sign a statement to confirm that you have received information about how much your franchise could earn, make sure that all information you received is included in the statement. Not doing so could waive your right to dispute any misrepresentations that affected your decision to buy the franchise.

 

Is a Franchise Model Right for You?

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.

 

Financial Requirements

  • How much money do you have to invest without overextending yourself? How much can you afford to lose?
  • Will you need to take on a partner in order to afford the startup costs?
  • Will you need financing? Do you have a satisfactory credit rating? Have you considered financing sources?
  • Do you have cash reserves (i.e. savings) or another income source to support you until your franchise becomes profitable?

 

Your Skill Set

  • Do you have experience in management or as a business owner?
  • Does the franchise you’re considering require special skills or training (i.e. accounting, decorating, or computer repair)? Do you possess those skills?

 

Your Goals & Preferences

  • Does the franchise’s prospective earnings meet your minimum annual income requirement?
  • Why do you want to buy a franchise? Why are you interested in this particular industry? Will this franchise opportunity provide what you’re looking for?
  • Does this franchise allow you to work your preferred number of hours per week?
  • Do you want to own multiple locations eventually?
  • Can you accept that this business model requires you to follow someone else’s rules?

 

Final Thoughts

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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