There are thousands of franchisers who would be happy to sell you a franchise, provided you can pay the franchise and you have the personal net worth they require in a franchise owner. Franchise operations are a common way for American businesspeople to get started. This is mainly because franchisers (think of McDonalds, Kinko's, and Subway) help reduce the entreprenuer's risk of losing his or her investment in a new business. Franchisers provide market research, advertising schemes, employee training, site selection, basic business training for owners, etc. The owner can then focus on the operation of the franchise business rather than going through all of the painful ``trial and error" experiences of getting a small business up and running. This reduction of risk is perhaps the main reason franchising is so popular.
The cost of starting-up a franchise operation is almost always documented very well by the franchiser, as are the projected revenues and ongoing costs after the start-up phase is over. This is often the source for all of those ``big profits" and ``high income-low investment" ads you see in so many newspapers and small business publications.
There is no doubting that franchising is an american way of life. Some estimates say that fully one-third of all retail sales are performed at franchise operations, and what is being sold, along with whatever product is actually for sale, is the brand name or goodwill of the franchisor. At any McDonald's across the country, you pretty much know what you are going to get on the food menu. Likewise, you know what services Kinko's will provide before you go into a Kinko's store. The franchisor spends a lot of money on advertising and market research to maintain the name recognition and commercial viability of the franchise operation's products and services. When you buy a franchise, you are buying a portion of this name recognition and market knowledge for yourself.
There are two types of franchise operations. The first is the entire business format (EBF). In the EBF, the franchisor (company selling the franchise operation) grants the franchisee (person buying the franchise operation) a license to use the trademarks, logos, business know-how, copyrights, trade secrets, purchasing power, etc. of the franchisor. In return the franchisor usually gets a slice of the franchisee's profits and/or a flat fee for use of the franchisor's intellectual property and services. The second type of franchise is the product distribution arrangement, in which there is a distribution system for a specific product under the manufacturer's name and trademark.
State and Federal Regulation of Franchisors
Franchise arrangements and the sale of franchise operations are governed by both state and federal laws. State laws usually require a franchisor to register its sales of franchise operations and provide a ``prospectus" or some sort of document disclosing the risks and other material information concerning the franchise operation. In this prospectus you will find the franchisor's financial statements, advertising materials, franchise agreement, and disclosures of material information concerning the franchise operation. The state then reviews these materials to make sure that they are understandable, relatively complete, truthful, and to determine whether the franshisor is able to keep the promises they make to franchisees. States then grant or deny a franchisor the right to franchise its operations in that state. Do not assume, however, that just because the state allowed the franshisor to register and sell its franchise operations that this means the franschise operation has some sort of seal of approval! All it means is that the state did not find a reason to refuse the franchisor's application to sell franchise operations within that state. You still need to do a lot of homework about the franchisor, and an investment into a franchise operation will involve considerable risk on your part.
The Federal Trade Commission also regulates franchise operations. The FTC rules governing franchise operations will be involved if the franchisor: (i) is granting the right to distribute products or serivices using the franchisor's tradename, (ii) will exercise significant control over the franchisee's operations, (iii) requires franchisees to buy products and services from the franchisor or its affiliates, (iiii) requires the franchisee to invest at least $500 within the first six months of operation. You do not need to worry about these threshold tests, however, since if the franchisor needs to be registered with the FTC, it almost certainly is registered with the FTC. (This is just some background information for you to have on the state and federal regulation of franchise operations.)
What should a buyer look for in a Franchisor
This is not an easy question to answer. With one-third of the country's retail sales occuring at franchise operations, the scope of business activities is quite large. Franchise operations sell everything from hamburgers to cars to software. This makes it difficult to say what qualities a good franchisor will have since each industry has specific concerns the franchisor must cater to.
But there are some general qualities in a franchisor that you should look for.
- Does the product or service being sold by the franchisor have a stable, growing or declining market?
- Within the particular market for the franchisor's product or service, is the franchisor's product or service well-recognized? Within the industry, is the market share of that product or service stable, growing or declining?
- What kind of reputation does the franchisor's products have in the market?
- How long has the franchisor been in the business? (longer is usually better, but not always)
- What are the backgrounds of the executives in charge of the franchisor? Are they new to the franchise game but old hands in the particular industry (or vice versa)?
- How many lawsuits between the franchisor and its franchisees are currently pending? How many have there been in the past? (People making a lot of money and getting along well do not usually sue one another!)
- What are the franchise fees used for, promotion of the franchisee's operations or profit-taking by franchisor?
- Is the franchisee a publicly-traded company or a subsidiary of a publicly-traded company?
- What goods and services are offered by the franchisor? Do you have to buy those goods and services or are they optional? If you must purchase them from the franchisor, what is the going market price for such goods and services? How does it compare to franchisor's price? (Making franchisees buy additional goods and services is a way franchisors can increase franchise fees without seeming to.)
- Does the franchisor offer training for franchisees and the franchisee's employees? If so, what are the costs associated with the training? Are there continuing training programs?
- Will the franchisor provide on-site managment help? If so, at what cost, if any? Will the franchisee be required to follow the advice of the franchisor representative, or can she make her own decision about whether to follow the advice?
- What is the franchise fee? Is it set in stone or a floating number? Are installment payments over time allowed?
- What are the royalty payments? How are they determined?
- What are the ongoing charges for advertising and promotion?
- What other fees are found in the franchise agreement? (E.g., accounting fees, site location fees, building rehabilitation or upgrade fees, etc.)
- What fees are refundable if you should opt out of the franchise agreement?
- What is the bottom line, total, ``no-more-salesman-bullshit" cost of starting the business and running it for a year? (You might have to ask other franchisees for this number.)
- Are there certain goods and services that you can sell and no others?
- Does the franchisor provide franchisees with financing for the purchase of a franchise operation?
Questiong to ask the franchisor concerning other franchisees already in operation
- How many are there?
- Where are they located (cities, states, countries)
- What is their profitability on average? (Note that averages can be deceptive if the franchises either succeed wildly or fail utterly, thus creating a nice sounding average.)
- What is the failure rate for franchise operations?
- How many franchises are going to be sold in the next few years? Where are they going to be located?
- Are franchisees given their own guaranteed territory?
Questions to ask other fanchisees
- Is it a good deal? Why or why not?
- What is the real rate of return on investment?
- What is your relationship with the franchisor?
- Are you happy with the support you get from the franchisor?
- What more could the franchisor do to help?
- What sort of competition do you face from other franchise operations? From other franchisees of the same franchise?
- Is the business seasonal or steady?
What you should investigate on your own
- Local population concentrations and demographic changes that may affect the franchise operation. (This will require that you know something about the customer base of the business.) Information concerning such demographic changes may be available from a variety of sources, including local real estate agents, chambers of commerce, advocacy groups, and government offices (Census Bureau, local planning commissions, etc.)
- If your business depends on pedestrian traffic or vehicle traffic, make sure you investigate local plans for directing such traffic patterns towards or away from the planned site of your business operation.
- Looking in small business publications such as magazines and books, how does the franchisor rate against other similar operations?
- If the franchisor is not a large, well-known operation, you should have an attorney or specialist carefully investigate the intellectual property right being offered by the franchisor. Specifically, the copyrights, patents, trademarks, and trade dress rights of the franchisor must be verified, and the franchisor should guarantee these rights to you and indemnify you for any loss as a result of the franchisor losing their rights to the same.
Getting out/Staying in
- What happens if you want to sell your franchise operation? Is the franchisor willing to repurchase it?
- What renewal rights do franchisees have when the franchise agreement expires?
- What option rights are franchisees granted on new franchise operations being offered in the local area or around the country?
- Can the franchise operation be passed on to children in the event of death, disability or retirement of current franchisee?
- What restrictions are there on franchisees who sell franchise operations and then open up competing businesses?
If you have not done so already, you should also consult our master checklist for starting a business for additional considerations on purchasing a franchise operation.
One last bit of advice: find yourself an attorney and an accountant with experience in representing franchisees, they will be a huge help.