florist holding beautiful flowers in flower shop
ComplianceLegalMay 25, 2023

Buying a small business franchise? Pros and cons of franchising vs. starting a business

small business services

Kickstart your new business in minutes

Find out what business type is right for you

Subscribe to Tax Talks Today

There are many choices when starting a business — you can start a business from scratch or you can buy an existing business. Among the existing business choices, you can decide to team up with a franchisor that has a proven business model already.

The franchise business model proved its advantages during the COVID-19 pandemic's economic uncertainty. The support from their franchise network allowed 50% of franchisees to effectively handle inflationary pressures and other challenges posed by the pandemic, as revealed by the IFA/FRANdata 2022 Franchisee Inflation Survey.

In this article:

Primary types of franchises

First, let's define the term franchising. 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.

Here are some primary types of franchises for new franchise owners.

Product and trade-name franchise: A product and trade-name franchise generally involve the distribution of a product through dealers. For example, auto dealerships are product and trade-name franchises that sell products produced by the franchisor. The most prevalent type of franchises in the United States are product or distribution franchises, constituting the largest proportion of overall retail sales.

Business-format franchise: Business-format franchises generally include everything necessary to start and operate a business in one complete package. Business format franchises provide the product, trade names, operating procedures, quality assurance standards, management consulting support, and facility design. Many familiar convenience stores and fast-food outlets, for example, are franchised in this manner.

Conversion franchise: A conversion franchise is when an established business becomes a franchise by signing an agreement to adopt a franchise brand and operational system. Business owners pursue this to enhance brand recognition, increase purchasing power, tap into new markets and customers, access robust operational procedures and training, and boost resale value. Real estate agencies, financial planning firms, independent hardware stores, and other service industries offer instances of conversion franchises.

Advantages of franchising

People are attracted to franchises because they offer a proven track record of success, as well as the benefits of business ownership and the support of a larger company. Franchises generally have a higher success rate than other types of businesses, and they can provide franchisees with access to a brand name, experience, and economies of scale that would be difficult or impossible to achieve on their own.

  • Minimal risk. A reputable franchise has a proven, well-defined and tested business model.
  • Name recognition. A well-known name gives instant recognition, bringing customers into the business and providing 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.
  • Business 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 franchises will assist the franchisee in selecting a site for the new franchise location.

Disadvantages of franchising

Purchasing a franchise provides the opportunity to leverage a well-known brand name, all while gaining valuable insights into its operation. However, it is essential to be aware of the drawbacks associated with buying and operating a franchise. If you are considering investing in a franchise, it’s important to take into account the following disadvantages of franchising.

  • Franchise fees. Franchise 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.
  • Attorney and accountant fees. Prior to purchasing a franchise with a substantial fee, it is important to have legal professionals review all related documents. Additionally, hiring an accountant well-versed in franchise and business financing is advisable. An experienced accountant can assist in comprehending the financial data provided by the franchise owner, evaluate the tax implications of the investment, and aid in setting up essential systems such as bookkeeping and payroll services.
  • Royalties. The cost of many franchises includes a monthly royalty (fee) based on a percentage of the franchisee's income or sales and must be paid 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, including branding and marketing.
  • Required purchases. The franchise may require the franchisee to purchase certain materials for the purpose of producing uniform franchise products. Franchisees can be expected to work with the franchisor’s supply chain.
  • 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 buyer.

Buying a franchise vs. starting a business

When deciding between purchasing a franchise and starting a new 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 +.

You want to be your own boss. If your answer is that you want to own your own 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 have to do it, and how you must 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 their golden arches ought to be bright green). You may be better off starting your own business.

You want to make a lot of money. If your answer is that 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 fees to the franchisor. You should look particularly hard at franchises if you don't have a great deal of hands-on experience running a business.

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, inventory, management counseling, hiring practices, and every other necessary function for the operation of your business.

Did you know? Franchises are particularly popular among downsized business executives and early retirees because they fit the ideal franchisee profile. They often have startup money in hand, but little experience in the industry.

Buying a franchise vs. buying an existing business

More difficult than deciding whether to buy a franchise or start a business from scratch is whether to buy a franchise or buy an existing business. The difficulty lies in the fact that both the franchise and the existing business have many similarities, such as:

  • Both a franchise and an existing business are (presumably) successful business concepts. If they weren't successful, you wouldn't be considering them now.
  • Both will cause you to pay a premium for the successful business concept. A franchise may be more costly due to its previous track record of success.
  • Both have name recognition. The existing business will have at least local name recognition while the franchise may have local and even national name recognition.
  • Both may provide management support. Management support should be inherent in the franchise purchase. Management support generally isn't included in the purchase of an existing business but can be structured into the deal by retaining the seller to stay on as a consultant for a period of time.

Related article: Buying an existing small business

There are several advantages to purchasing a franchise over buying an existing business:

  • Management support. One of the core concepts of a franchise is that the franchisor provides management support for the life of the franchise. Even if a seller has agreed to remain a consultant for an existing business, that consulting arrangement is for a limited period of time. After the consulting arrangement ends, the buyer is on his or her own.
  • Greater exposure. A franchise will usually provide greater exposure to new customers through national advertising campaigns and name recognition.
  • Costs shared. Expenses that apply to each franchise, such as advertising, may be pooled to take advantage of group discounts.
  • Increased chance for success. Franchising succeeds only if the individual franchisees are successful. Thus, the franchises are packaged in a manner that will enable the franchisee to succeed. The franchises are usually based in whole or in part on previously successful franchise arrangements. In comparison, an existing business may not have any history other than its current one. Although an existing business is successful for the current owner, that success may not transfer over to another owner.
  • Proven business methodology. A franchise can provide a training program to teach the franchisee about the business operation and industry, even if the franchisee has no prior experience.

When choosing between a franchise and an existing business, you must decide whether these extra benefits are worth the cost you'll have to pay for them.

Finding a franchise to buy

If you're considering buying a franchise, there are several places to look. If you have a pretty good idea which franchise you're interested in, the most obvious place to start is with the franchisor. The franchisor can give you all the information you'll need about purchasing a franchise.

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 may save money because you are not paying the franchisor a franchise fee since you are taking over an existing franchise.

You may, however, pay the equivalent of a franchise fee to the franchise seller if the seller is asking a premium for the franchise being sold. You can determine whether the premium is reasonable by comparing it to the cost of a franchise fee for a new franchise. A franchisor may be able to provide you with the name of an existing franchisee who is looking to sell his or her franchise. Finally, some franchisors may buy back and operate franchises from franchisees until they can find a suitable buyer.

Following is a list of places to look for franchises for sale:

  • Franchise trade shows. These trade shows also 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. Among the larger conferences are the IFA Annual Convention, the Multi-Unit Franchising Conference, and the International Franchise Expo. There are also a number of organizations that hold regional conferences, such as The Franchise Shows produced by National Event Management.
  • Online directories. There are a number of Internet sites that list franchises for sale.
  • News publications. Most news publications, from large metropolitan publications to small local publications, have a classified ad section (online and/or print) in which businesses and franchises are listed for sale.
  • Business brokers. Another route to finding a franchise is to go through a business broker. A business broker matches people who want to buy a franchise with people who are selling one. One of the benefits of using a broker is that the broker, at least a good one, will screen franchises that are for sale to determine if there are major problems and to make certain that the franchise being sold exists. However, the broker's fee to sell the franchise will probably result in a higher sales price.

Evaluating the franchisor

Buying a franchise, like making any other major purchase, 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 the right decision.

What to look for. In general, a prospective franchisor should have 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 cautious!) Try to determine whether the franchisor is attempting to expand the number of franchisees as quickly as possible (which may be at the expense of existing franchisees).

Try to answer as many of these questions as you can when considering a franchise:

  • Is there a prototype location that is the basis for the franchising operation?
  • Is the franchise too dependent on the founders of the franchise?
  • Is there a strong management team of officers, directors, and consultants who understand the industry and the use of franchising as a means of expanding the business?
  • Is there enough capital to support the franchising program and provide assistance to franchisees?
  • Is there a recognized and distinctive trade identity that is a registered trademark? Does the franchise have a uniform trade appearance and overall image?
  • Are there methods of operation and management that are proven? Have they been incorporated into an operating manual?
  • Is there a comprehensive training program for franchisees?
  • Is there support staff that can visit and assist franchisees?
  • Is there support staff that can monitor and enforce quality control standards?
  • Are there legal documents that reflect the franchise's history, strategy, and policies?
  • Is there a strong market for the products or services that the franchise offers?
  • Are there site selection criteria based on market studies and demographic reports?
  • Does the franchisor have a record of refusing to renew the franchise if a new franchisee is particularly successful so it can take over the operation itself?

Keep in mind that this is not an exhaustive list of items to investigate. It's a starting point that identifies the main items to investigate.

Where to look. A franchisor must provide offering documents to prospective franchisees. According to federal law, the offering documents must be given to the prospective franchisee at the first meeting between the franchisor and the franchisee where the purchase of a franchise is seriously discussed. In any event, the offering documents must be given to the prospective franchisee no later than 10 days before the franchise agreement is signed or before any cash is paid.

The federal government, as well as most state governments, have rules and regulations regarding the content of the offering documents. The federal government approved a format, called the Uniform Franchise Offering Circular (UFOC), that has been adopted by virtually every state. It requires offering documents to be written in "plain English." The UFOC and other offering documents include the following information:

  • The history of the franchise.
  • The history of its owners.
  • Procedures for terminating and renewing the franchise relationship.
  • Quality controls.
  • Fee structures.
  • Financial statements.

Creating a franchise agreement

A franchise agreement is a contract between the franchisor and the franchisee. The agreement should balance the interests of the parties. However, in reality, if the franchise is a well-known organization like McDonald's Corporation, the franchise agreement is going to be more favorable to the franchisor. If the franchise is more obscure, you'll have more opportunity to negotiate favorable terms for yourself.

There really is no such thing as a standard franchise agreement because each contract will be drafted to suit the individual situation. Here is a partial list of items that entrepreneurs should look for and understand in a franchise agreement:

  • Use of trademarks
  • Franchise fees and other payments and costs
  • Obligations and duties of the franchisee
  • The territory refers to the designated area or region exclusively assigned to the franchisee.
  • Restricted covenants encompass a range of actions that both current and former franchisees are obligated or prohibited from undertaking.
  • Franchise agreements often feature an extensive guaranty section, aiming to ensure that the franchisee's new business covers reasonable expenses owed to the franchisor.
  • The franchise agreement encompasses provisions regarding renewal rights as well as policies governing the transfer, termination, or cancellation of the franchisee's rights.

Making the franchise decision

Once you have found a franchise and have completed your investigation, all that's left is the final purchase decision. Here are a few suggestions for things you should think about before you make that final decision:

  • Make absolutely sure that you've gathered all the information you can. Above all, don't rush into the decision until you've explored every avenue of the franchise.
  • Make sure that the franchisor is reputable. When we hear "franchising," we often think "safe." But there are plenty of unscrupulous franchisors out there. Franchising is so popular these days not just because people are eager to buy, but also because people are so eager to sell them. There is a lot of money to be made by those who sell franchises.
  • Make sure that you show the information you gathered to your lawyer and accountant. Ask them if they think buying the franchise is a good idea.
  • Make sure that your decision is from the head as well as the heart. Don't buy a franchise, for example, just because you liked eating there once. Don't buy it unless you are reasonably sure that you can make some money from it.

Overall, franchising can be a good option for entrepreneurs who want to start a business with a proven track record of success. However, it is important to carefully research the franchise opportunity before making a decision.

small business services

Kickstart your new business in minutes

Find out what business type is right for you

Subscribe to Tax Talks Today

Back To Top