Starting a franchise business can be easier than starting from scratch but there are a lot of franchise risks you’ll need to avoid
There are more than 3,000 franchise companies in the United States, each looking for hungry entrepreneurs to drive their brand.
As an investment analyst, I’ve covered franchise businesses like McDonald’s and KFC and seen how the franchise agreement works for franchisees and for the corporation. Starting a franchise business can be a great opportunity for new entrepreneurs but there’s also a lot of risk.
On the franchisee side, I’ve seen these risks through an uncle that started a sandwich franchise in Las Vegas. There’s more to it than most hopeful business owners realize but it can also be much easier than starting your own company from scratch.
You’re most likely going to be putting your life savings into the franchise to get started and spending most of your time there every day. Understand what you’re getting with a new franchise business before you take the leap.
What is a Franchise?
A franchise is a legal agreement between a brand owner, a corporation, and an individual business owner to license that brand. The individual business owner pays a startup fee and regular payments to the brand owner in return for help launching and operating the business.
Generally, the franchisor provides:
- Management and Staff Training
- Financing Assistance
- Site Location for the Franchise Business
The franchisee brings their own entrepreneurial drive and day-to-day management of the business. While the company can help get you start a franchise business, the ultimate responsibility for profits is on you.
The franchisor retains legal rights to the business brand and generally restricts the franchisee on how they can operate the business.
How is Starting a Franchise Business Different from Creating a New Business?
Starting a franchise opportunity is easier than launching your own business in most respects. You won’t have to file for incorporation and the company may take care of a lot of the legal paperwork for you. Franchisors have a vested interest in your success so will help you get started with site selection and understanding how to be successful.
Your new franchise business will already benefit from brand recognition, usually on a national scale. This will help get new customers because they’ll already know what you do and hopefully will have some level of trust in the brand.
Most franchisors will interview potential franchisees before offering a contract to make sure you have the managerial experience and drive to be successful. If you pass the interview process…and if you have the required startup costs, you’ll be presented with a franchise agreement to sign.
Most franchise businesses have some form of training program to get you started. This can be as intense as an in-person campus experience with multiple professors or as simple as a self-study program and a workbook.
Advantages of Starting a Franchise
The advantages of franchising come from the proven brand and the assistance getting started. Starting a new business is tough even for someone with experience in management. You don’t have to start from scratch with a franchise and will have someone there to help guide you.
- A lot of franchisees scoff at high initial fees and overlook the advantage in a proven brand. It’s expensive to get customers for a new company. Developing a level of trust within a community can take years and lots of money. Using a brand with which people are familiar already usually means a faster start and more customers.
- Unless you’ve worked in the industry for a while, you may not know everything there is to running the business. The franchisor has successfully developed its brand and helped launch other franchisees.
- One of the hardest parts of running your own business is having to be everything at once. You have to be management, logistics, marketing and a finance person within the 168 hours available each week. Starting a franchise business brings with it the marketing department of the corporation and maybe help from other departments as well.
Not all franchise opportunities come with strong brands and training that can help make you a success. There are scammers in franchising just as with any other type of business. If the franchisor can’t deliver on some of these advantages, start looking for a different company.
The company should provide help in writing a business plan but you’ll want to detail it out as much as possible. You want to have every question answered before you jump into the commitment.
Need a business loan to start your franchise? Lending Club offers franchise loans up to $350,000 on terms up to five-years. Requirements are $50,000 in annual sales and two years of operations but no collateral is needed for loans of $100,000 or less.
Disadvantages of Franchising
So if franchising is so great, why doesn’t everyone do it rather than start their own company? The advantages of franchising are matched with some fairly heavy costs along with disadvantages.
- High startup costs and required expenses may come with your franchise. Fees alone will be tens of thousands to get started, on top of location costs and other expenses. The company may also require that you buy equipment or supplies from them and you’ll pay a percentage of sales on a regular basis.
- The franchisor needs to protect their brand and will have strict requirements on how you can run your franchise. You won’t be able to make all the decisions like you would with your own business and may have to wait for corporate approval to do anything new.
- Franchisees are dependent on the corporation for marketing and one bad commercial can hurt the brand and your sales. Other franchisees can also hurt the brand and affect your bottom-line.
- The franchisor has ultimate control over the brand and the contract. That includes renewing the contract and prices that may not be as favorable as they were initially.
Despite these disadvantages of starting a franchise business, it can still be a lot easier than starting out on your own.
More than $24 billion in bank lending went to franchisees over the 16 years to 2017 through the Small Business Administration’s 7(a) loan program. The success rate of payment on those loans averages just above 80% meaning four-in-five franchisees are able to pay off their loan. That doesn’t necessarily mean the franchise is successful but it’s a good indication and much better than the 34% success rate of small businesses over ten years.
How to Buy a Franchise
An absolute must in being a successful franchisee or in starting a business from scratch is to have prior experience in the industry. If there is one thing you get from this article, it’s this. Before you buy a franchise, get to know the business and what makes it successful.
That means working in the industry for at least a year or two. If you’re thinking of opening a fast food restaurant, work in one for a while. Learn the different roles from wait staff all the way up to management.
You are likely going to be putting down your life’s savings and maybe more into your franchise. Know the business inside and out before you commit.
The franchisor is required to disclose all fees and costs in a Uniform Franchise Offering Circular (UFOC) before you put your money down. The details provided include:
- Initial Franchise Fees which can be anywhere from $10,000 up to a million or more. The average franchise fee for a small brand is around $25,000 but fees for large chains like McDonald’s are into the millions.
- Ongoing Franchise Fees are usually paid as a percentage of your revenue as well as a fixed monthly payment. The average royalty franchise fee is around 5% of revenue but can go much higher.
- Marketing Fees are paid into a company advertising fund. Franchise marketing fees are generally around 2.5% and mostly go to nationwide advertising.
- Mandatory Product or Services purchased through the company is another expense franchisees have to deal with and can sometimes be significant. You may be required to buy furnishings, equipment, promotional materials or services from the franchisor. These are usually a per item cost so ask to see a catalog of prices so you can compare against retail purchases to make sure the franchisor isn’t using required purchases to take advantage of franchisees.
Adding up these costs and getting an idea on average franchisee revenue is critical to making the decision. Don’t just take the franchisor’s word about average revenue, try talking to a couple of current franchisees or look on the web for benchmarks in the industry.
If the company also owns some of its own stores and releases financial information to shareholders, you might be able to get an idea of average revenue per corporate-owned store. On the average franchisee revenue, you’ll need to build in an estimate for sales in your intended location.
Don’t forget to add in all your other operational costs to run the franchise including staffing, utilities, local marketing and any insurance not covered by the corporation. If you plan on financing the franchise with a loan, deduct interest payments from operating profits and then take some out for taxes.
Some franchisors may provide a business mentor to new franchisees. If someone isn’t assigned to you personally, try finding a business mentor from someone in your local community to help guide you.
CNBC surveyed more than 28,500 franchise business owners in 364 brands for its America’s Star Franchisees series. It selected a franchisee from each state to share their numbers. It’s an interesting read but understand that these are highly successful franchisees, most of which own multiple locations, and make several times the revenue compared to the average franchisee.
One of the biggest mistakes franchisees make is forgetting to account for the time they’ll spend running the business. A few grand in projected profits each month may sound great until you realize you’ll be spending 10+ hours a day running the franchise. Add in the stress of a make-or-break situation and it may not be worth it unless you can grow the business quickly.
Most franchise contracts will also include an agreement on how many competing locations can be sold in a specified area. If this isn’t spelled out plainly, make sure to ask. Try to negotiate a grace period of at least a couple of years during which no new franchises can be started within an area around your business and that you have first right to buy new locations rather than compete against new franchisees.
Understand that even if you don’t have to worry about competition from another franchisee of the same company, you will probably have to compete against other franchises in the same industry. Success draws other franchises out of nowhere and will lower profits. It’s a common theme in franchising, just ask anyone that manages a video rental store or a fitness center.
Starting a franchise can be a great alternative to starting your own business from scratch but there are also disadvantages and risks you’ll need to avoid. Make sure you’re passionate about the business and ready to spend long hours making your franchise a success. Look at the numbers carefully and only go into the franchise agreement if you are absolutely confident you can make it work.