The Basics of Franchising: Will You Start the Next “Subway”?

Written By: Daniel Hart

Edited By: Salene Kraemer

                   From time to time, we have clients buy into a franchise or occasionally want to franchise his or her own business concept.

                 Franchising is a business model that combines aspects of working for yourself and working for someone else.  It is an efficient system for an individual who wants to own/run a business but lacks the experience to do so.  Within the United States, there are about 3,000 established franchise brands operating in over 200 different lines of business.  A franchise is a legal and commercial relationship between the owner of a trademark, trade name, and business system (franchisor) and an individual or group wishing to use that identification in a business (franchisee).  The most common form of franchising is product/trade name franchising in which a franchisor owns the right to a trade name and/or trademark and licenses the rights to use those.

Buying a franchise offers many advantages that is not available to an individual starting a business from scratch.  Here are a few examples:

•  Proven business system and brand name. Through years of experience and trial and error, franchisors have developed a business system and brand name that are successful.
• Pre-existing business relationships. Many franchises have existing relationships with suppliers, distributers, and advertisers that franchisees can utilize.  Entrepreneurs must develop these relationships on their own.
• Quality market research. Typically, a franchisor will perform substantial market research into competition and the demand for the product or service in a specific location before allowing a franchisee to open a franchise there.

Similar to an entrepreneur opening their own business, a franchisee must spend a substantial amount in order to obtain their own franchise.

• First, there is an initial franchise fee, which is a one-time charge assessed to a franchisee in order to use the business concept and trademarks, attend training program, and learn the entire business.  Franchise fees can have varying ranges depending on the size of the franchise system.  This can range from as low as $2,000 to over $100,000.
• Depending on the specific type of business that you franchise, a variety of additional up-front costs can occur.  These costs include rent/construction cost of building new facility, equipment, signage, initial inventory, working capital, and advertising fees.

After these initial costs and fees, a franchisee generally pays the franchisor royalties running around 5 to 8 percent of gross revenue plus contributing funds to a company-wide advertising program.

Many people may ask “why should I pay tens of thousands or hundreds of thousands of dollars before I start and then a royalty percentage every year after that?”  For some, the answer is clear.  By opening their own franchise of an already successful name-brand business, many can make more money quicker than opening their own business.  Also, there is a greater likelihood that long-term return on their investment will be realized.

As with starting any business, it is vital to perform due diligence before investing in a franchise.  Here are some examples of basic information you need to discover before committing to a franchise:

 

• Research growth potential. Simply, you need to make sure that there is a strong-likelihood that you can increase profits and have a successful business.  Also, is there a market for your business where your location will be?
• Check consumer and franchise regulators. Check these within your state to see if there are any serious problems with that company. Check with the Better Business Bureau for any complaints against the company.
• Search public court records. Is the company involved in any litigation? If so, determine the nature of the lawsuit.  If the nature of the lawsuit involves fraud or regulatory violations, that is a bad sign.
• Request a Franchise Disclosure Statement: By law, this document must be given to all prospective franchisees at least 10 business days before any agreement is signed. A franchise disclosure statement (FDD) contains an extensive description of the company.  It includes information such as amount of fees required, any litigation/bankruptcy history, trademark information, advertising program, equipment you are required to purchase, and the contractual obligations of both franchisor and franchisee.  If a franchise will not give you a FDD, you probably should not do business with that company.
• Contact other franchisees: The FDD should contain a list of existing and terminated franchisees. Use this list to your advantage.  Contact current franchisees in order to gain insight as to whether or not the training was helpful, how well the franchisor responds to your needs, and whether sales/profits met their expectations.  Reach out to a couple terminated franchisees as well.  Ask why their franchise agreement was terminated.  Was it due to lack of business, bad franchisor, or for some other reason?  Also, if the list of terminated franchisees is quite lengthy, that might be a sign that that franchise is not doing well.
• Visit a current franchise location: This can give you a lot of information. You can determine whether or not that franchise has a healthy flow of customers.  You might get an in-person conversation with a current franchisee and see how the operations are run.

By performing due diligence, you will have a clear picture as to whether or not you will buy a successful franchise and whether or not you will be doing business with a helpful franchisor or not.

Finally, work with a lawyer and accountant when undergoing the franchising process.  Lawyers have expertise in performing research and can assist in reviewing and negotiating the franchising contract.  An accountant can review any financial reports concerning the franchise and project profitability for the future.