SBA Research Shows Franchise Businesses Fail at Higher Rate Than Independent Businesses.
Could buying a franchise be a chance to control your financial destiny or the path to financial disaster?
With the economy making jobs difficult to find, many people are considering business ownership as a viable alternative to the job market.
One alternative many look to first is a franchised business.
If you’re thinking about buying into a franchise, I urge you to proceed carefully. This path is risky if not done right.
Between the franchise fee - which can range from $25,000 to $100,000 (and sometimes even more) - the start-up costs, working capital, and the 6 months to 1 year of living expenses (before the business supports you), franchisees can end up spending $50,000 to over $300,000.00 to get into and start a franchised business.
That’s often much more than it would cost to start an independent (non-franchised) business or to buy an existing business.
Franchise buyers justify the additional expense because they believe franchise systems give them a higher chance of success.
Most of them have never owned a business before. They rightfully believe that small businesses are very risky. So they want the security of a support system. They want to be in charge of their own destiny, yet have someone to rely upon for help.
But are franchises truly less risky? Do they provide security? Are they worth the money?
Believe it or not, according to research conducted by the U.S. Small Business Administration the answer may be NO!
SBA research has shown that independent small businesses have a better chance of surviving than small franchised businesses!
What?
That’s right. The SBA research discovered that franchised businesses had a 6% higher failure rate than the rate for independent businesses.[1]
According to the SBA research:
- Starting an independent business was less risky than buying into a franchise system; and
- Independent entrepreneurs are in business longer and do better financially than franchised businesses.
Other SBA research also determined that 56% of franchise systems did not exist within 4 years after they started franchising, and a full 75% of franchise systems did not exist within 10 years.[2]
That means that more than half of franchisors get out of franchising within 4 years and 3 out of 4 are out of franchising within 10 years!
Two recent articles in Entrepreneur Magazine (January 2010 issue) cataloged several recent franchise concepts that have failed (including eBay drop-off stores, meal preparation stores and dating franchises) and how a franchisee dealt with the franchisor’s bankruptcy (Cork and Olive franchise system).
What happens to the franchisees that bought into those franchise systems?
Even though they paid tens of thousands of dollars of franchise fees for support and assistance, they no longer have it. If they buy products from the franchisor, they can’t get inventory. And they’re left on their own.
That certainly sounds risky.
You may wonder if all franchisors are at risk? The answer is that not all franchise systems are the same. There are good ones and bad ones.
How can you tell the difference?
You have to be sure that: (1) you’re getting what you need to get into business faster and make more money than you would in an independent business; (2) once you grow that business, you’ll be able exit it and realize the wealth you’ve created; and (3) the franchisor has staying power.
How do you know which franchisor will help you create a great business and which one will leave you in a financial bomb crater?
You have to know what the franchisor is providing for the franchise fee, and understand the information in the Uniform Franchise Offering Circular (UFOC) and the Franchise Agreement.
The 3 Things Every Franchise MUST Provide.
Every franchise must provide each franchisee at least these three elements:
- Recognizable Registered Trademark.
- True Turnkey Systems.
- Valuable (and inexpensive) Business Assistance.
These three elements enable a good franchisor to open new franchise locations, to hire and train employees effectively and to get new customers quickly. Remember, buying into a franchise means starting a new business from scratch. These three elements are supposed to get you up and running and make you successful faster than doing it without the franchise.
Trademark. The trademark brings customers to the franchised business because its readily recognized by the market the franchise serves. If that market doesn’t know the trademark or, god forbid, the mark doesn’t come with a good reputation, don’t buy the franchise. You’ll be better off with an independent business.
(By the way, getting in on the “ground floor” when the franchisor doesn’t have a well known mark, isn’t 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, that the mark has been published for opposition and, that the mark, once registered for a period of time, 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. Turnkey systems enable franchisees to work in a business where they have little or no experience and to get things up and running quickly. You can determine whether the franchise systems are adequate by talking with (and secret shopping) other franchisees.
(By the way, this is actually 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 says something about taking more time than expected to get up and running, this is a red flag the franchisor’s systems may not be as good as they should be. If there’s any indication that the sales and marketing system isn’t as good as it should be, you shouldn’t buy the franchise.
Assistance. 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.
ou 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.
You MUST understand all of the Information provided in the Uniform Franchise Offering Circular (affectionately known as the UFOC).
Although it may seem like pages and pages of legalese and seemingly irrelevant and useless information, you have to carefully read the UFOC and know what to look for. The UFOC will tell you a lot about the prospective franchisor and the franchise system.
You have to know what’s there that shouldn’t be and what needs to be there but isn’t. You have to know the little tricks that franchisors use to make more money and harm your profitability. You have to know what things that seem harmless come back to bite you weeks and sometimes 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 franchisee gets its money off the top. It’s an additional expense that is paid first and that reduces your net profit.
If you say 5% or 6% because that’s the royalty rate, you’re wrong.
Instead, you’ve got to add the royalty rate and the advertising fees (because you don’t get to say how the advertising money is spent and, very often, it won’t be used to grow your business, only to build “brand awareness” for the franchisor) and compare them against the bottom line you expect from the franchised business.
For example, if the franchise you’re considering charges a royalty rate of 6% and the advertising rate of 2%, and you anticipate the bottom line net profit for a business of this type, after paying yourself a reasonable salary, should be 15% of gross revenue (for an independent business), then the franchisor will be getting 8% of gross revenue and your net profit should be about 7% of gross revenue. This means that the franchisor gets 53% of the profit and you get 47% of the profit.
Of course, you have to include other fees and charges in that calculation. Many franchisors require franchisees to buy supplies from franchisor vendors. If those supplies are overpriced (typically because the franchisor gets a ‘commission’ from the vendor), then the extra charges have to be added into the franchisor payments.
You also have to know what you’re getting for all that money and what it would cost you to buy those benefits outside a franchise.
If the franchised business in the above example generates gross revenue of $750,000 annually, then you’ll be paying the franchisor about $60,000 per year and you’ll net about $52,500 (excluding your salary).
You have to ask: “What products or services could you buy for an independent business for $60,000 per year?” and “Is the franchisor obligated by the franchise agreement (no verbal “promises accepted”) to give you at least those products and services?”
This example ignores the up-front franchise fee and other franchise specific expenses, which should be added to those numbers.
The above examples are only a couple of the business and legal issues to be considered. Other areas include renewal provisions, non-compete provisions, whether you have the right to require the franchisor to enforce the territory restrictions, franchisor assistance obligations and whether the franchisor can impose changes on you that require more capital investment.
Frankly, reviewing the UFOC and the Franchise Agreement are areas where you’ve got to get experienced professional advice. 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 so you can evaluate the alternatives from starting an independent business to buying a going concern business.
Conclusion
Using these methods will help you determine if a franchise is worth your investment and help you avoid losing tens or hundreds of thousands of dollars on an inadequate or failing franchise, or a franchise that’s just a plain bad deal.
[1] Survival Patterns Among Franchise and Nonfranchise Firms Started in 1986 and 1987, Dr. Timothy Bates.
[2] Differences Between Successful and Unsuccessful Franchisors, Dr. Scott Shane.
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