ComplianceFinanceDecember 13, 2020

Should you buy a small business franchise?

Starting a franchise has its advantages and disadvantages, compared to buying an existing business or starting a new one from scratch. Still, there are special considerations, and becoming a franchisee makes you a partner in a larger business structure.

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.

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.

Primary types of franchises

There are two primary types of franchises. 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.

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.

People are attracted to franchises because the best ones have proven to be extremely successful over the years, and they combine many of the benefits of business ownership with the brand name, experience, and economies of scale provided by the established corporate franchisor. In fact, good franchises generally have a higher success rate than other types of businesses. Let's take a look at the advantages and disadvantages of franchising.

Advantages of franchising:

  • Minimal risk. A reputable 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 franchises will assist the franchisee in selecting a site for the new franchise location.

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.
  • 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.
  • Required purchases. The franchise 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 buyer.

Franchise vs. existing 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 choose.

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.

A lot of people in the franchising field will tell you that franchises have a failure rate of about five percent, compared to the 30 to 50 percent failure rate of independent entrepreneurs.

You should be aware, however, that some studies have questioned the five 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's study also found that the average capital investment of franchisees was $500,000, compared to $100,000 for independent entrepreneurs.

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 that 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.

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 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.

There are several advantages to purchasing a franchise:

  • Continuous 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.
  • Less risk. 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.
  • Complete 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 buyback and operate franchises from franchisees until they can find a suitable buyer.

Another 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 at Trade Show Central and The Ultimate Trade Show Resource.

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

  • Newspapers. Most newspapers, from large metropolitan publications to small local publications, have a classified ad section in which businesses and franchises are listed for sale. Some, such as The Wall Street Journal, even have a specific classified section of businesses for sale.
  • Internet. There are many Internet sites that list franchises for sale. You can do a general search of sites that offer franchises for sale, or you can do a specific search for the particular franchise operation you are interested in. Since this is a relatively new method of locating businesses for sale, you should approach this method cautiously.
  • 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 for you.

Investigating 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 new 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. However, there are some basic terms that pertain to the franchisor and franchisee in most franchise agreements.

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 before you buy. 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. Consequently, a lot of people, some of whom are unscrupulous, are drawn to franchising.
  • Make sure that you show the information you gathered to your lawyer and accountant. Ask them if they think 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.
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