For many budding entrepreneurs, franchising a business is an attractive option. It allows them to become a business owner using processes and systems which have been shown to work in the field, reducing risk and cost. However, before you start a franchise business, you need to be aware of the pitfalls and find way to select, evaluate and ultimately sign up with a franchise in a more intelligent manner.
We Tried Once and we Failed (or so we thought?)
The tips outlined below come from the personal experience my wife and I had when we decided to open a franchised fast-casual style restaurant about 7 years ago. The whole process of selecting a franchise to negotiating an agreement, site selection and eventually deciding to terminate the agreement took a little more than a year. It was a very stressful time for both of us. Like many would be franchisees, we were going through this process while we were both holding a job. Eventually we decided to terminate the agreement after we decided that the franchiser support during the process was lacking. It did not bode well for the kind of support we could expect to receive after the restaurant was up and running. We did lose our franchise fee in the process. But frankly, now when we look back at that time and the decision we made, we are quite happy that we terminated the franchise agreement and took the loss. Similar fast-casual restaurants in that cuisine are now closing down at an alarming rate in our area.
Of course, franchisers vary in what they offer in terms of support and stability. But even if you are going with a recognized brand, you still need to be careful. Cosi is a very popular chain of sandwich shops which is in financial trouble. Chi-chi’s, long a fixture in our community, has shut down. Many auto-repair and transmission franchises are in trouble as well. It is wise to do your research before you sign on the dotted line, even if you see these franchises all over the country.
Tips You Need to Consider Before You Decide
1. Do a Thorough Due Diligence
This should include reviewing the historical financial statements, doing a Google search to find the legal history of the franchiser, looking at the resumes of the management team, etc. Financial statements are very important and a careful review along with the franchise historical growth rates should give a good indication of whether the product is popular with the consumers. A franchiser who loses money is likely to increase royalties and other fees in the future. In our case we had a franchiser who broke even for the past 3 years and underwent several management changes not properly explained to us. This was a red flag for us. Non-audited historical financial statements was another.
A franchiser will not reveal a typical annual sales figure for a franchise. Sometimes this can be deduced by looking at the royalty numbers on the Franchiser P&L, dividing it by the number of open franchises that year and multiplying the result by the royalty factor (if the royalties are 5% of the sales, than you need to multiply by 20). Keep in mind that these numbers may not be accurate due to franchises that may have opened in the mid year or franchises that may have closed down during the year. You may need to make appropriate adjustments.
2. Review the UFOC Multiple Times and Use a Lawyer
An UFOC document (Uniform Franchise Offering Circular) should be presented to the potential franchisee early in the process. Make sure that you read the document word by word a few times. Than hire a lawyer and have him go through it. Even though UFOCs are now written in plain english, a lawyer should still be a part of your team. Many times there are clauses that appear harmless but can cause a conflict in a manner that you may not be aware. You cannot negotiate a change in the UFOC. The final Franchise Agreement will be based on the UFOC but you can still negotiate amendments to the Franchise Agreement that will need to be attached to the document. We requested amendments to allow us to operate the restaurant under a different name if the franchiser goes bankrupt. We also negotiated a narrower scope on the non-compete clause. Do not skimp on the lawyer. A few thousand dollars extra spent at this stage can mean avoiding tens of thousands of dollars in expenses later on.
3. Interview Current and ex- Franchisees on Phone and in Person
This is very important as a franchiser will not tell you if you are going to be profitable. By law, they are not allowed to give out numbers or make claims. The only way you can gauge if this can be a profitable business is by talking to existing franchisees. I recommend to go and visit a few franchisees in person at their place of business so you can also see if the place is busy. Talk to the ex-franchises to understand why they left the franchise. If they had support or other issues or if the business was not profitable, you need to understand and know this early in the process. Although it did not dawn on us at that time, the franchiser accompanied us to the franchises we visited (under the guise of showing us around). This put the current franchisee on guard so they would not reveal information that they should not (but that you really want them to talk about candidly)
4. Define Your Exclusive Territory
You want to ensure that the franchiser does not offer a franchise to someone else in the close proximity to you. At the same time you want to make sure that if the franchiser limits the number of stores in a certain radius and if this radius includes an airport or a hospital than the airport and hospital are exempted from the limits. You may want to open another store in the airport within your exclusive territory. This will not cannibalize your sales as the airport traffic is very different from your local neighborhood traffic.
5. Evaluate Franchiser Support and Help
Franchiser support and help will make or break your business so it is vitally important that you observe the process for clues on how this is working. Interviewing current and ex-franchisees helps. This was the straw that broke the camel’s back for us. The franchiser only allowed us to work with his appointed real-estate broker to find a location and negotiate a lease but the real-estate broker assigned to us was very unresponsive to our questions. So much so that some of the best locations we had our eyes on were scooped up by competitors within months while our agent procrastinated.
6. Protect Your Franchise Fee
We lost our franchise fee due to what we felt were legitimate issues in the franchiser performing his duties but we did not have a legal ground to ask for a refund. It may be possible to put in a contingency clause in the franchise agreement that allows for the fee to be returned. If that is not possible, try to delay paying the fee as long as possible or negotiate an installment based structure for the franchise fee based on achievement of certain milestones.
7. Understand Your Start Up Costs Early
A Franchiser will give you a range of what the typical costs are, but you need to understand the costs in your local market. Go ahead and start making calls to the contractors if a store front needs to be built. This way you will also get a head start on a contractor selection process.
8. Understand Your Time Commitments
If you are looking at a restaurant franchise, forget about the possibility of running it part time while holding a full time job. It may be possible later if you can find a trustworthy manager but in the beginning you will have to devote time until you are able to build trust AND your business gains profitability. There may be certain franchises that can be run absentee but not many. Also remember that for most franchises, you will need to commit some time and money before the start up for training for yourself and your employees.
9. Form Complete Picture of a Typical P&L
This is important and you will need to pick up clues as you go along in the franchising process by talking to different people and preparing financial models. It would be helpful to build a business plan for the business as you go through the process. You will need to consider sales volume, traffic, employee counts, payroll, rent, utilities, inventory, franchise fees (royalties, advertisements, etc), as well as any regulatory compliance expenses.
10. Choose Location Carefully
This is a very important factor in determining if your business will be profitable or not. You need good traffic from the demographics that your business is targeting. Opening a Kinko’s in a mall is not advisable, regardless of amount of traffic in the mall as this is not a traffic well targeted to your business. Also if you are looking to open a store or a restaurant in a busy office building, you will have very little night traffic or traffic from young people. Some of this is common sense, but a large part of this is doing careful research on demographics, traffic patterns and future development plans for the area.
Deciding to start a franchise can be life changing and you want to make the process as stress free as possible. Do not make the same mistakes we made. The real work begins when you start your franchise and become a business owner. Hopefully these tips would help you get there easier and safer.
Are you a franchise owner or have you thought about owning one? What has been your experience. Please let us know and join in the discussion.
Shailesh Kumar is an Entrepreneur, investor and blogger. He writes about value investing at Value Stock Guide. Learn about the stock market and discover the techniques proven to work best for long term investors for finding appropriate stocks to buy in their portfolio to get superior risk adjusted returns.