To Buy or Not to Buy: Three Things EVERY Franchise Must Provide
Before you purchase a franchise, you must consider the decision carefully. With the sizeable franchise fee on top of the normal costs to get the operation up and running, you will likely pay considerably more to open a franchise than if you were to start your own business or buy an existing independent (i.e. non-franchised) business.
These higher costs are justified by franchisees because they believe the proven concept, in-place systems, and available support network will provide them with a relative degree of safety and risk mitigation that they wouldn’t have with an independent business.
However, this belief is likely founded on faulty and misinterpreted data. You need to verify that the franchise system can offer you these benefits and that the franchisor will help you create a great business. To do this, you must know and understand these three things:
- What you get in return for the franchise fee,
- The disclosures and information in the Franchise Disclosure Document (FDD),
- The terms and conditions of the Franchise Agreement.
Franchise Fee Perks
As I said, franchise fees can range from $10,000 to over $100,000 for a “Master Franchise.” This cost doesn’t include normal start up costs for the business, it is literally just the cost to buy in to the franchise.
In return for that fee, the franchise system promises to provide the franchisee with certain perks. Not only do you get the right to use its recognized brand, but you also get access to its training and management systems and business support systems.
If you are considering buying into a franchise, always make sure that the franchise system can provide you with these THREE things:
- Recognizable Registered Trademark,
- True Turnkey Systems,
- Valuable (and inexpensive) Business Assistance.
These three elements enable a good franchisee to open new franchise locations, to hire and train employees effectively, and to get new customers quickly. Because of the higher costs associated with opening a franchised business, it’s vital that you get up and running and start turning a profit as quickly as possible—more so than if you were operating an independent business.
This is exactly what these three elements are supposed to allow you to do and is the most basic benefit of franchised operations: efficiency.
The trademark brings customers to the franchised business because it’s readily recognized by the market. When your operation opens, the local consumers will automatically associate your brand with a certain type and level of product.
Trademark and product recognition is vital to your success. You can’t spend the time and money marketing and building a customer base. If that market doesn’t know the trademark or it doesn’t come with a good reputation, don’t buy the franchise. You’ll be better off with an independent business.
Some franchise brokers will try to encourage buyers to consider newly-franchised businesses (i.e. with an unrecognizable trademark) because they can get in on the “ground floor.” I just do not think this is a good deal. You’ll spend your money to develop their mark, and you won’t get the long-term benefit from doing it.
The trademark should also be registered with the United States Patent and Trademark Office. Registration means that a government lawyer has reviewed and approved the mark and that the mark has been published for opposition. Once the mark has been registered for a period of time, it will get special protection. In other words, there’s a much higher likelihood that the mark is valid and can be protected by the franchisor.
Turnkey systems enable franchisees to work in a business where they have little or no experience and to get things up and running quickly. There are front of house systems such as employee hiring, training, operations, and management as well as back of house systems like inventory, distribution, and shipping. Of course, what systems are in place depends on the industry.
You can determine whether the franchise systems are adequate by talking with (and secret shopping) other franchisees. Unlike with the purchase of an independent business, you can and should tour a prospective franchise. In fact, in my opinion, this is an absolute requirement for prospective franchisees before committing to a franchisor. You have to physically shop, visit, and talk with multiple franchisees in all franchise territories, near and far, before you buy.
If the franchisee’s employees aren’t following the system or the franchisee mentions that it took her longer than expected to get up and running, this is a red flag that the franchisor’s systems may not be up to snuff. If there’s any indication that the sales systems or marketing systems are inefficient, you shouldn’t buy the franchise. This goes double for vendor or inventory systems, which can have terrible effects on your income.
When you’re having a problem with your business, you want someone who understands your business on the other end of the phone or visiting your location and who can provide meaningful suggestions and assistance. You don’t want to call the franchisor only to be read what’s in the operations manual.
You can determine whether the franchisor provides appropriate assistance in franchisee interviews and by investigating the background and experience of the people the franchisor uses to provide that assistance.
Franchise Disclosure Document (FDD)
Although it may seem like hundreds of pages of legalese and seemingly irrelevant information, you have to carefully read the Franchise Disclosure Document (FDD) (pre-2007 it was known as UFOC) and know what to look for.
The FDD has 23 “items,” which tell you a lot about the prospective franchisor: its litigation history, the franchise system and management, and (critically) your legal obligations and rights as a potential franchisee. (Also included with the FDD is the Franchise Agreement, which we will look at below.)
You must carefully read and fully understand these 23 disclosure items. You have to know the little tricks that franchisors use to make more money and harm your profitability. You have to know what things seem harmless but can come back to bite you weeks—or years—later. You have to know the signs that a franchisor is likely to fail. You have to know how much the franchise truly costs.
For instance, how much of a “partner” is the franchisor in your business? I say partner because the franchise gets its money off the top. It’s an additional expense that is paid first and that reduces your net profit.
A big mistake made by first-time business buyers is thinking that the franchise system’s cut of their profits is limited to the typical 3%–4% royalty rate. In reality, it’s much more. You’ve got to add the royalty rate and the advertising fees then compare them against the bottom line you expect from the franchised business. (As an aside, you don’t get to say how the advertising money is spent, and, very often it won’t be used to grow your business. The franchise system will use it to build “brand awareness.” So, you should consider this fee a cost.)
For example, if the franchise you’re considering charges a royalty rate of 4% and an advertising rate of 2%, and you anticipate the bottom line net profit for a business of this type should be 15% of gross revenue (i.e. were this an independent business, you’d net $0.15 for each dollar of sales), then the franchisor will be getting 6% of gross revenue and your net profit should be about 9% of gross revenue. This means that the franchisor gets 53% of the profit and you get 47% of the profit. So, if this franchise generates a gross revenue of $750,000 annually, then you’ll be paying the franchisor about $45,000 per year and you’ll net about $67,500 (excluding your salary).
Of course, you have to include other fees, charges, and expenses in that calculation that independent businesses don’t have to pay. For example, many franchisors require franchisees to buy supplies from franchise-approved vendors. If those supplies are overpriced (typically because the franchisor gets a “commission” or branding license fee from the vendor), then the extra charges have to be added into the franchisor payments. Again, this information should be contained in the FDD (item 8), so it’s vital that you read and understand that document.
This example ignores the up-front franchise fee and other franchise-specific expenses, which should be amortized over the life of the franchise.
Graham came to my office with a bulky FDD in hand. After retiring as an executive with a large company, but not yet ready for a traditional retirement, he thought he’d use part of his retirement package to get into a business a little less stressful than his position with a Fortune 1000 company. He was looking at a food franchise in a well-worn area, but whose concept was more in line with today’s family.
With the franchise fee, build out, initial marketing fees, and other expected costs, all told, the initial costs to get into this franchise were more than $350,000. Because he was building out a new location, between governmental approvals and contractor work, he wouldn’t open for at least 90 days.
We amortized the startup costs over the franchise term of seven years and analyzed the information about other franchisee performance in Item 19 of the FDD. Unfortunately, assuming Graham’s location performed similar to other franchise locations, his return on investment over the franchise term would be less than five percent.
Graham’s franchisor sales manager told Graham he was looking at this all wrong. He told Graham that he would make the money in the second franchise term. But, the second franchise term was not guaranteed—it was at the option of the franchisor. Plus, extending the time for a return on his investment doesn’t correct for the problem of there being insufficient return for the risk in the first seven years.
Graham correctly decided that a 5% ROI wasn’t sufficient to take on the risk of the franchised business and began searching for other business opportunities that were more in line with his expectations. He could put the money into real estate or another investment and achieve a higher rate with less risk and lower costs for liquidating his investment.
The above examples are only a couple of the business and legal issues to be considered. Other areas include:
- renewal provisions,
- non-compete provisions,
- franchisor assistance obligations,
- whether you have the right to require the franchisor to enforce the territory restrictions, and
- whether the franchisor can impose changes on you that require more capital investment.
As I said, the franchise agreement is also included in the FDD. It is the legal document that creates the franchisor-franchisee relationship and allows the franchisee to use the franchise’s trademark, systems, etc.
Like any other business contract, it’s important to read and understand each provision. You can and should review the franchise agreement with an experienced lawyer to decide whether the provisions, as written, suit your business and life goals and whether they offer sufficient legal protections to you. Rarely will they. Certain provisions may be up for negotiation and an addendum may be added to the Franchise Agreement to address these outstanding issues.
Even though franchisors are often reluctant, or flat out refuse, to change any provisions of the franchise agreement, you have to know what you’re getting into before you commit your hard-earned dollars.
Proceed with Caution
On the surface, buying into a franchise can be appealing. It offers those with limited business experience a ready-made and no-hassle path to business ownership and financial freedom. Someone else has done the hard work to create a concept, build a brand, develop supply, sales, and training systems; all you have to do is pay to use them. Because everything is pre-packaged, as it were, you can get up and running in minimal time and start turning a profit quickly.
However, the simplicity is often deceptive. It costs more to buy into a franchise system than it does to start your own business or to buy an independent business. And if you rushed into your purchase blindly, you may have purchased a franchise that can’t actually offer you a recognized trademark, true turnkey systems, or business support—the exact things a franchise purports to provide its franchisees!
As we have also learned, it is a myth that franchised businesses are less risky than independent businesses. This doesn’t mean they are necessarily a bad choice! For some entrepreneurs, franchise businesses are a perfect fit, for others, not so much.
The bottom line is that you need to seriously consider whether a franchise is worth your investment. Rushing headlong into a franchise purchase risks you losing tens or hundreds of thousands of dollars on an inadequate or failing franchise, or a franchise that’s just a plain bad deal.
How Can We Help You?
Here at Alexander Abramson, we focus exclusively on business-related legal matters. We have advised closely held businesses and business professionals for years on everything from raising startup equity and partnership arrangements to selling a business, and, yes, also franchise opportunities.
Our staff strives to create a wonderful client-experience by actively listening and maintaining open lines of communication, consistently meeting deadlines, and being upfront about our pricing and services. Don’t trust the legal needs of your business to an attorney that can’t or won’t offer you the best service possible.
We would love to speak with you directly about how we can help you start, grow, or sell your business.
Call us 407-649-7777 to set up an initial consultation.