Posted on 18 September 2014.
By Paul D’Amato, SCORE Counselor and former franchise Owner
Franchising accounts for 40 percent of all retail sales in the United States, employs over 18 million people and accounts for roughly $1.5 trillion in output. Many people that are interested in becoming an entrepreneur look at franchising as a viable option to help them start a business. Be careful.
Franchising is not for everyone, and it is likely you will work at least as hard or harder for yourself as you do working for someone else. If franchising is something you are considering, here are some things to think about before going too far:
Is the business a good fit for your personality?
Nearly all franchise companies will tell you that they have such a clearly defined business that anyone can run it. Even if this is true, and I feel in many cases this is just a sales pitch, it is important that you are happy doing whatever it is. For example, there are some excellent franchises that rely on the franchisee making sales calls. If you are skilled at sales and enjoy it then these franchises may be a good fit for you. However, some people may hate to make sales calls and a business that relies on the franchisee making sales calls may be a big mistake. Whatever business it is, don’t kid yourself into thinking that you can get someone else to manage it. You will be extremely involved and will be overseeing every aspect of the business. Because of that, it is critical you find something that is exciting for you and is a good fit.
Due diligence is a term given to the process of verifying for yourself that the business is what it claims to be. You should plan to spend as much time as it takes in this process to make sure that you understand exactly what you are getting into. A full description of due diligence is certainly beyond the scope of this article, but I do want to point out a few of my favorite things to look at when I first start looking at a franchise.
It has been very enlightening for me on several occasions to compare what franchisors claim for time commitment against what the actual franchisees are saying the time commitment is. Recently I was looking at a franchise that claimed on one of its video presentations to take no more than 10-15 hours per week for the franchisee. In fact, they said that you could easily run this franchise and continue to be involved full time in another job. This seemed almost too good to be true to me, and when I started talking to franchisees it turned out that it was. I called and talked to five different franchisees in various parts of the country and every one said that they were spending at least 40 hours per week running the franchise and that it was a much greater time commitment than what they had been led to believe. Be sure to do your homework and research.
The central question of every investor in a franchise should be; are you going to make money? Unfortunately, this can be one of the most difficult questions to answer. It is not required that franchisors make an earnings claim in their disclosure materials to you. Many franchisors do not make a claim about earnings because it opens them up to liability with their franchisees. If the franchisor tells you that you are going to make a 20 percent return on your investment and you lose money, the franchisor might end up in court. So, although there are arguments why some franchisors do not make earnings claims, I would be leery of any franchisor that is unable or unwilling to give you any information about how your investment might do. I would be much more inclined to invest in a franchise that publicly makes an earnings claim.
Whether the franchise gives you an earnings claim or not, you are still going to have to verify profitability by talking to existing franchisees in the business. Unfortunately, franchisees can be hesitant to give you actual numbers. It would be very rare for a franchisee to fax you their income statement and balance sheet for instance. However, I have been quite successful in asking enough questions that I arrive at a pretty good picture of how they are doing. For example, asking how many customers they have and their average ticket price per customer is a good way at getting their gross sales figure without asking directly.
I have a good friend who is a business consultant at McKinsey and one of his favorite questions to ask his clients is “okay, but what then?” If everything works well, and in 10 or 15 years you want to retire, will you be able to? Some franchises do not allow the transfer of the franchise to another party. On the other side, some franchises are more than happy to buy you out at a fair price whenever you are ready to sell. It is much easier to ask these kinds of questions before you get involved with a franchise than once you have signed on the dotted line. It is always good to have an exit strategy even if you never use it.
Similar in some ways to an exit strategy is what is sometimes called an “evergreen provision.” This provision in the franchise agreement gives the franchisee the right to transfer the franchise to your kids without the franchisor blocking the transfer in some way. Personally, I would love to be able to pass a business along to my kids someday so this is another thing I look for.
Defined Territories / Encroachment
Most lawsuits in franchising seem to come out of encroachment. Encroachment is when the franchisor opens another store right across the street from your store and half of your customers leave. This is a nasty practice and certainly something that you should be very careful to research before you enter in to any franchise. What makes this subject so complex is that you want lots of branches for brand recognition – just not right next to your branch. One of McDonald’s strengths, of course, is that they have locations all over the world. However, even McDonalds has to be careful not to open their branches so close together that neither can survive. Exactly how this is managed varies from franchise to franchise, but is a very important thing to take into account. The policy should be clearly spelled out in the agreement so you don’t wake up and find a new location right across the street.
Franchising is a very important part of business in the US and the rest of the world. Franchises come in virtually every industry and in a myriad of shapes and sizes. I would encourage people who are planning on becoming an entrepreneur to look into franchising as an option. As my mother says, “you won’t know any less.” But you need to be careful. Do extensive due diligence. Talk to franchisees, talk to your friends, get advice from accountants, get counsel from lawyers, and come into the SCORE office in Grand Rapids (111 Pearl St. NW) for some free advice paid for by the Small Business Association. wwwscoregr.org