ComplianceLegalFinanceJanuary 30, 2021

Consider pros and cons before buying a franchise

“Franchising” refers to an arrangement in which a party, the franchisee, buys the right to sell a product or service from a seller, the franchisor. The right to sell a product or service is the franchise.

A product and trade-name franchise generally involves the distribution of a product through dealers. Common examples are auto dealerships and some gas stations.

Business format franchises provide the product, trade names, operating procedures, quality assurance standards, management consulting support, facility design, and generally everything necessary to start and operate the business in one package. Many familiar fast food outlets and convenience stores are business format franchises.

Some major advantages of franchises are:

  • Risk minimized -- A well-established franchise is a proven business method.
  • Name recognition -- A well-known name can bring customers into the business and provide a competitive advantage for the franchisee.
  • Training -- A franchisor can provide a regimented training program to teach the franchisee about the business operation and industry even if the franchisee has no prior experience.
  • Support -- A franchisor can provide managerial support and problem-solving capabilities for its franchisees.
  • Economies of scale -- Cost savings on inventory items can be passed on to the franchisee from bulk purchase orders made by the franchisor.
  • Advertising -- Cooperative advertising programs can provide national exposure at an affordable price.
  • Financing -- A franchisor will generally assist the franchisee in obtaining financing for the franchise. In many instances, the franchisor will be the source of financing. Lenders are more inclined to provide financing to franchises because they are less risky than businesses started from scratch.
  • Site selection -- Most franchisors will assist the franchisee in selecting a site for the new franchise location.

On the other hand, here are some of the disadvantages:

  • Franchise fees -- These fees are required to be paid to the franchisor at the inception of the franchise agreement. These fees can range from a few thousand dollars to hundreds of thousands of dollars, depending on the franchise.
  • Royalties -- The cost of many franchises includes a monthly royalty (fee) based on a percentage of the franchisee's income or sales, and you pay even if the business is not profitable.
  • Loss of control -- Franchise agreements usually dictate how the franchise operates. The franchisee must adhere to the standards in the franchise agreement, which thereby leaves the franchisee with little control over the operation.
  • Required purchases -- The franchisor may require the franchisee to purchase certain materials for the purpose of producing uniform franchise products.
  • Termination clause -- The franchisor may require that it retain the right to terminate the franchise agreement if certain conditions are not met. The franchisor may then terminate the agreement and offer the franchise location to another.

In deciding whether to buy a franchise or to start an independent business, perhaps the best place to begin is to ask yourself why you want to own a business. The answer you give may provide some insight into which path you should choose.

You want to be your own boss. If your answer is that you want to own a business because of the freedom it will bring you, you probably shouldn't buy a franchise. If you buy a franchise, the franchisor will dictate much of what you have to do, when you do it, and how you do it. You'll have far more control if you start your own business.

You have a business idea that you believe has a lot of promise. If you want to nurture an idea you have into full bloom, you probably shouldn't buy a franchise. You won't have much control or be given much of an opportunity to pursue your ideas (try telling McDonald's that they need to provide waiters and real silverware).

You want to make lots of money. If you want to own your own business because of the financial opportunities it presents, you should look long and hard at a franchise. Franchises don't necessarily make more money than other types of businesses, but they do have higher success rates. Of course, you'll be paying for the higher success rate in the fees you'll be paying to the franchisor. In many cases, you need to own several franchises to become really wealthy.

You have money but you're looking for something to keep you busy. If you have startup funds in hand, a franchise may be ideal for you, particularly if you lack hands-on experience. You'll get help with everything you need to set up your business: site selection, inventories, management counseling, hiring practices, and every other necessary function for the operation of your business.

Warning: a lot of people in the franchising field will tell you that franchises have a failure rate of about 5 percent within five years, compared to the 50 percent failure rate of independent entrepreneurs in the same time frame.

You should be aware, however, of recent studies that question the 5 percent rate. For example, a study by Dr. Timothy Bates, a professor at Wayne State University in Detroit, found that the franchise failure rate actually exceeded 30 percent and that franchises made lower profits than independent entrepreneurs. Dr. Bates’ study also found that the average capital investment of franchisees was $500,000, compared to $100,000 for independent entrepreneurs.

Finding the right franchise. If you're not sure which franchise you're most interested in, a good place to look is at annual franchising trade shows. These trade shows provide an opportunity to talk to many franchisors and industry experts in one location. Often, the shows will have seminars to educate potential franchisees on what they can expect and the advantages and disadvantages of being a franchisee. Details of trade shows can be obtained on the Internet.

If you have a pretty good idea of which franchise you want to own, the most obvious place to start is by contacting the franchisor. The franchisor can give you all the information you'll need about the availability, cost, and other details about their franchises.

An alternative that isn't so obvious, but that can achieve the same result, and possibly at a savings, is to contact existing franchisees who are looking to sell their franchises. You might save some money because you may be able to avoid some of the initial franchise fees.

Investigate the franchise before buying. Buying a franchise, like buying an existing business, should involve a thorough investigation. The time spent investigating the franchise, the industry, and the market will make you confident that your decision to buy (or not to buy) was on the money. Making the wrong decision can cost you tens of thousands of dollars or more, not to mention the loss of time and energy on your part, so don't give short shrift to this very important step.

Before you buy, you should be convinced that the prospective franchise has an established reputation, sufficient capital, high-quality products or services, and satisfied franchisees.

A reference list of current and former franchisees should be available from the franchisor. (If a reference list isn't available, be very cautious!) Talk to as many of these people as you can--they are the ones who can give you the inside story about the business.

Mike Enright
Operations Manager
small business services


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