Chapter 5: How to Analyze and Invest In a Restaurant Franchise
If you are considering opening a franchise restaurant, this chapter will be invaluable in giving you details about the ins and outs of franchising. The information can help you make an informed decision about whether franchising is for you.
CHOOSING THE RIGHT FRANCHISE
You are interested in buying a franchise, but how do you know which franchise is right for you? Which franchise will suit your individual knowledge, skills, goals, and preferred level of involvement? By choosing the right franchise, your chances of success increase substantially — most failed franchises result from a buyer not doing sufficient research to find the franchise that suits him best. This chapter will help you decide how to choose the perfect franchise and will tell you where to find the information essential to making your choice.
FRANCHISES ARE NOT INDEPENDENT BUSINESSES
The first thing any franchisee must realize is that a franchise is not an independent business. Franchising is not for you if you are the type of person who needs exacting control over your business. Do not forget: When you purchase a franchise, you are simply providing the capital to enable another person’s dream, idea, or product to enter the marketplace. Why? Because it has already proven its worth — it works.
Most independent businesses fail within three years of their launch. A large amount of capital, time, energy, and personal sacrifice is needed to make an independent business succeed.
If you have a big, new idea for a product or service that you are sure consumers cannot live without, perhaps establishing an independent business is the way to go.
There are many resources available to help you decide whether your business idea is worth pursuing.
• Check out the Service Corps of Retired Executives (SCORE www.score.org). The Corps partners with the U.S. Small Business Administration (SBA) www.sbaonline.sba.gov and offers the advice and counseling of retired business executives to those thinking about starting an independent business. SCORE can help with financial planning, creating and following a business plan, and other issues that are critical to starting a business.
• The Small Business Development Center (SBDC) www.sbaonline.sba.gov/sbdc is another organization affiliated with the SBA. The SBDC has 63 of its own centers across the nation, as well as more than 1,100 offices within local schools, colleges, and chambers of commerce. Your local SBDC can provide you with technical and management assistance for your independent business.
Before establishing an independent business, you should do extensive market research on your idea. Is it appealing to consumers? Will it have a market? Have SCORE and an SBDC review your findings and point out any weaknesses. Also, be sure that your idea is economically feasible. Will your costs (rent, inventory, taxes, fees, payroll, insurance, legal fees) be covered by your revenue? Is your product pricing fair? Do you have a supportive and reliable bank? Once again, use SCORE and an SBDC to be sure your financial calculations make sense.
BECOMING A FRANCHISEE
Establishing an independent business may seem like a lot of work. It does hold a great amount of risk. If you do not have a unique product in mind and you want to build upon the proven success, reputation, and customer base of an established product or service, then franchising is your answer. Unlike independent businesses, decisions are made for you by experienced industry professionals. Your name, trademark, and product line are known, trusted, and recognizable from day one.
Going this route, you still have a large decision to make — which franchise is right for you? Which franchise will keep you interested, will make proper use of your skills and knowledge, and will bring you profit in the end? You have a number of options as you begin to gather the information to choose the right franchise.
You may want to consider visiting a franchise broker. Brokers have low fees and can match you to a franchise based on your education, skills, and psychological attributes. Brokers match you based upon a small list of available franchises. Brokers are paid by franchisers to market their businesses. That means brokers will not suggest all possible options, but only those businesses with which they are in partnership. To find the perfect franchise, narrowing your options by visiting a broker is not your best bet.
I suggest gathering your own information to make the most informed choice. A number of resources exist that can help you remain organized during the information-gathering stage. Keep detailed records of names, databases, and websites. Be sure to record which information goes with which franchise or industry. Such detailed analyses will prove invaluable when the time comes to make your final selection.
Begin your information gathering by making a list of questions. Write these questions down and do not stop gathering information until you have a satisfactory answer to every one. Try to find the overlap in your questions and answers. How do the questions and answers interact? Such observations can provide you with even deeper insight.
What kinds of questions should you be asking? Consider your personal needs or expectations, company and product longevity, competition, and modernization. Research the company’s past financial records and its relationship with other companies. Research where the market and technology are heading and assess the company’s products and services in that light. Has the company stayed up to date with current trends? Are there any upcoming introductions of new products or services that might threaten the company’s own products and services? How would the company respond? Is the company expanding? Is it focused? What kinds of services and support does it offer its franchisees? Is the labor attractive? Would you be able to offer competitive pay rates?
The answers to your questions can be found on the Internet, in franchise and business directories, in books and magazines, and at trade shows.
Internet
As with all Internet research, be careful of your sources. You should check the individual websites of the companies you are considering taking a franchise with.
Directories
A number of franchise directories are available to assist you. Directories are the best place to begin the information gathering process.
• Franchise Opportunities Guide www.franchise.org. Published bi-yearly by the International Franchise Association (IFA), this guide contains essential information such as the names and contact information of franchisers, suppliers, and legal consultants specializing in the franchise industry. It also includes franchise statistics and articles of interest to the franchisee. You can order the guide through the IFA at 800-543-1038 or on the IFA website for $17.
• Franchise Update Publications www.franchise-update.com. This organization publishes a number of guides, including Executive’s Guide to Franchise Opportunities, Food Service Guide to Franchise Opportunities, Guide to Multiple-Unit Franchise Opportunities, and Franchise Update Magazine. These are essential publications. For information about ordering them, go to the website or call 800-289-4232.
• Bond’s Franchise Guide www.worldfranchising.com. This guide covers both the United States and Canada and includes contact information for more than 1,000 franchisers. It costs $29.95 and can be purchased at 800-841-0873 or via the website. World Franchising also publishes a number of helpful books.
• Franchise Annual www.infonews.com. This guide also publishes franchiser contact information, along with brief business descriptions and fees. The guide is available online and can be purchased for $44.95 or by calling 716-754-4669.
• Franchise Handbook www.franchise1.com. This handbook is published quarterly and contains information about companies offering current franchise opportunities. The handbook contains relevant articles and success stories. You can subscribe to it for $29.95 a year at 800-272-0246 or via the website.
• International Herald Tribune International Franchise Guide www.franchiseint1.com. This annual publication, printed by Source Book Publications, contains information on international franchising. It can be purchased for $29.95 at 510-839-5471 or from the website.
Consumer Business Publications
There are a number of business publications and newspapers you should consult for information that is useful to the future and current franchisee:
• Inc., www.inc.com
• Entrepreneur, www.entrepreneurmag.com
• Franchise Times, www.franchisetimes.com
• Franchising World, www.franchise.org
• Franchise Update, www.franchise-update.com
• USA Today, www.usatoday.com
• The Wall Street Journal, www.wsj.com
• The New York Times, www.nytimes.com
Trade Shows and Expositions
Franchise trade shows may be the best source for information. They offer the opportunity to meet face to face with prospective franchisers. You should leave a trade show with brochures, pamphlets, and other great tools for answering the questions you wrote down at the beginning of the information-gathering stage.
The world’s largest trade show, the International Franchise Expo, is sponsored by the IFA and is held annually in Washington, D.C. This gathering includes hundreds of organizations offering franchises to interested individuals and includes classes for an extra fee. It is well worth a visit. Information can be obtained from the IFA at 1501 K Street NW, Suite 350, Washington, D.C. 20005, www.franchise.org, or 202-628-8000.
Additional smaller shows are held every year. Your local SBDC might hold low-fee seminars of interest to you. Regional trade shows are held throughout the year and could include franchise opportunities specific to the needs and market of your region. Check the Internet for these.
Keep the following things in mind when visiting a trade show.
• Make sure you are dealing with a franchise and not some other kind of business opportunity. Many companies at trade shows offer “multi-level marketing plans” or other such business plans. These are not franchises. The best way to ensure that you are looking at a true franchise is to ask for a copy of the company’s Uniform Franchise Offering Circular, or UFOC. These circulars, which must conform to FTC regulations, ensure that the company is offering a true franchise. They contain a wealth of relevant and important information about the franchise opportunity. You may be asked to sign for the circular and to provide your contact information. That is acceptable. Taking a UFOC and reviewing it does not mean you are under any obligation to buy a franchise. Companies are required to abide by a ten-day “cooling off period” before selling a franchise, giving the prospective franchisee and franchiser time to reconsider and clear up any mistakes. By providing your contact information, the company can ensure that you purchase your franchise legally. Franchises cannot be purchased legally at a trade show.
• Have a plan before you walk into the trade show. Take the time to look at the show directory before the event and know which franchises you want to examine. Structure and organization are your most important allies. Have any specific questions about your chosen franchises ready beforehand.
BUYING AN EXISTING FRANCHISE
Often companies provide a list of existing franchise locations that are available either from a current franchisee or from the company directly. Such locations provide the benefit of being already established, with a presence in the community and an existing customer base. These locations already have trained employees and many may be willing to stay through the change in management. Taking over such a location can save you months of preparation and allow you to bypass such time-consuming steps as finding a location, negotiating a lease, and hiring.
Before you purchase an existing location, be sure to research its history. Some owners might be planning a retirement, looking for a new occupation, or have other such innocuous reasons for “getting out.” It is possible that the location is suffering and the owner is looking to “unload” on another buyer. Do not count on the existing owner to provide you with all the information you need to make an educated choice. Use all the resources at your disposal to discover what you need to know about a location’s history. Check media sources, public records, and available financial data. Is the owner legally obligated to share any franchise information? If so, it would be good information to have and would be useful to you.
If you find that a location’s history is not favorable, you need to be able to determine the cause of any failures. Sometimes a new owner with energy and foresight is all that is needed to bring new life to a beleaguered franchise. However, location problems, competition problems, or other such issues may be harder to overcome.
Purchasing an existing franchise will cut down on advertising, hiring, and other costs associated with opening a new location. However, you will likely have to pay a transfer fee (a fixed fee or a percentage), in addition to legal fees. Be sure to pay close attention to the terms of the new franchise contract. Some owners may sell you only the remainder of their own contract rather than a new, full-term contract. If you are interested in finding existing franchises that are up for sale, take a look at the Business Resale Network website: www.br-network.com.
STARTING NEW
If you would rather purchase a franchise and open a new location, odds are that you will not be entirely on your own. The help you may receive in this endeavor will vary from company to company. While the franchiser will often help you to locate an appropriate property, sign a lease, advertise, and hire help, be sure of the quality of the assistance you will receive before agreeing to the purchase.
Getting to know the franchiser and its other franchisees in person is a good step to take in deciding if the franchiser will provide you with the aid you need as you begin your business venture. Take a trip to company headquarters — it is well worth the expense. Talk to the staff, evaluate the premises, and decide if the company is well-run. If it is not well-run and if there are disgruntled staff members at headquarters, chances are that franchisees are also unhappy. Take any invitations to tour premises and other outlets, but also take the initiative to visit some outlets unexpectedly. If you are touring with other interested franchisees, make yourself known and share information.
Ask current franchise owners if they have received satisfactory aid from the parent company. Ask about any problems they have encountered and how the problems were solved, as well as how much capital was required for them to set up their franchise and how long it took for them to begin realizing a profit.
You should expect a quality company to want to get to know you as well. Good, responsible companies will only want to sell franchises to responsible franchisees. If a company takes your check without any kind of interviewing or examination of your background, how interested are they in the success of their company and how interested will they be in you and your personal success after that check is cashed?
If you are satisfied, begin to search for the right site to establish your new location. Consider such things as demographics, traffic patterns, crime, zoning, future construction projects, and competition in the immediate area. Interview pedestrians or other local business owners to get an idea if your franchise will be welcome and successful in the neighborhood.
Stay organized, stay focused, and use all the resources available to you. Choose the right franchise and take intelligent initial steps, and your chances of success will increase dramatically.
DOING YOUR RESEARCH
When it comes time for the nitty gritty of research, organization and preparedness are key. You will be inundated with material during your search for information. This chapter will help you to tackle the stacks of paper you are likely to collect.
INTERNET RESEARCH
The Internet is beneficial in that it allows companies and individuals to publish and disseminate information freely. This open use can also be a hindrance because the quality of information on the Internet varies widely. Despite this fact, the Internet is going to be your primary tool as you collect preliminary and background information.
If you were to go to “Google” and enter the word “franchise,” you would find more than 60 million results. Internet research is most useful if you focus your search on companies, products, or services in which you have an interest. The Internet is only a starting point, a means to gather contact numbers and general information. In the end, you will need to make phone calls, attend interviews, and “get out there” to gather information to make an intelligent decision.
Separate The Good, The Bad, And The Ugly
For effective Internet research results, you need to learn how to sort the useful from the worthless. It is helpful to be on the lookout for certain characteristics that are very common among untrustworthy or illegitimate franchising sites. This section will give you some useful tips.
• Look for disclosure information. While many companies will provide UFOCs in electronic versions on the Internet, you should be aware that the federal government has yet to make these electronic versions legal. A franchiser who delivers these documents in electronic form is not abiding by FTC regulations and should not be trusted. If a website with such UFOCs provides a disclaimer stating that electronic documents cannot be used to buy or sell a franchise, you can be more confident that the company is legitimate and trustworthy.
• Check for the quality of grammar and spelling on a site. Poor spelling and grammar are often a sign that something is amiss. Professional, legitimate companies will post only well-written information on their websites.
• Avoid doing business with companies that have “hype” on their sites. A good company can sell itself with facts, figures, and other concrete indications of success. A company that tries to sell itself with overblown statements and self-accolades has nothing substantial to say.
• Avoid sites with overly aggressive marketing. As in the previous tip, a truly successful company will be able to sell itself with facts rather than aggressive sales tactics or intimidation.
• Avoid dealing with a company that does not provide full financial details at the outset. You should be able to browse estimated setup costs, fees, cash flows, and other such financial information freely. Companies that hide this information probably have even more to hide.
STARTING POINTS
I would like to recommend a few starting points to those who have no idea where to begin. While my list is in no way exhaustive, it contains great sites with trustworthy information.
Franchises are heavily regulated by state and national governments, so governmental websites often contain a large amount of useful and trustworthy information. I suggest you begin with the Federal Trade Commission www.ftc.gov. The FTC plays a large part in the regulation of franchises and disseminates a great deal of information for franchisees. Here you can find laws, legal actions, investigations, and proceedings against faulty franchisers.
I recommend these sites: Entrepreneur magazine at www.entrepreneurmag.com; www.franchise.com; the IFA at www.franchise.org; www.franchisesolutions.com; and www.franchiseopportunties.com.
STAYING ORGANIZED
Print out the information you find on the Internet. You will probably get a massive amount of printed material at franchise expositions. Rather than creating slipshod piles around your home or office, you will be best served by systematically organizing these materials.
Prepare to organize your materials even before you begin collecting them. Visit your local office supply store and purchase an affordable filing system, along with hanging folders, tab folders, and labels. As you begin to gather information, create a separate file folder for each company you correspond with. Within each company folder, create subfolders for such categories as correspondence (letters sent and received, contact information, memos, faxes, and business cards); promotional items (brochures, glossies, and other printed information); legal items (UFOCs and contracts); and operational items. This last category, which will come into play once you have made a deal with a franchiser, will include items concerning operational specifics such as potential locations, suppliers, and employees. Additional categories can be created according to your own needs, but the above categories (at minimum) are suggested for careful organization of your materials. Such a filing system will be a great help as you attempt to locate specific information quickly.
Even after you have purchased a franchise, keep the information you have filed. You never can tell what might happen in the future and having your self-created database at your fingertips will be a blessing should you change your mind about your purchase.
TERRITORIAL STRATEGIES
If you own a franchise with territorial concerns, your franchiser will have set up territorial rules and limitations for you. You should be aware of how territorial conditions are arranged and understand how they are formed by your franchiser. Three considerations must be taken into account: 1) whether multi-unit franchising is an option, 2) how territories should be made up, and 3) whether franchisees should be allowed to expand their existing territories.
MULTI-UNIT FRANCHISING
A franchiser needs to decide whether one or multiple units will be made available for sale to a single franchisee. Multi-unit franchising can take one of three forms, which are outlined and described below.
Master Franchising
In this system the franchiser sells a master franchisee the right to recruit and train other franchisees in exchange for royalty payments or a portion of the franchise fees collected from these additional franchisees. This arrangement is great for the growth of the franchise system in that it reduces the franchiser’s overhead by cutting down on permanent headquarters staff and reduces conflict caused by excessive market growth. In addition, master franchising makes buyback easier by reducing the number of people with whom the franchiser must deal during the buyback of a unit.
When knowledge of a particular market or locale is needed, master franchising is great because the franchiser is able to work with someone established in that market. This knowledge is beneficial when a franchiser is looking to expand internationally, as the master franchiser will be familiar with local customs and currency and able to judge the worthiness of potential franchisees in that region or country.
Master franchising does have its drawbacks. New franchisees lose some of their incentive for success because they do not hold an exclusive contract. Second, master franchising makes quality control much more difficult. In addition, the selection of a single bad franchisee can inflict serious damage on the system as a whole.
Area Development
In this system a franchisee is given the right to a large area with the potential to host more than one outlet. The area is thus given to the franchisee for development. This system puts a stop to the piggybacking of individually owned franchises in a single area on one another’s advertising efforts and reduces the total number of franchisees to manage. In addition, this system requires less training and development on the part of the franchiser, as not every newly opened outlet needs guidance, information, and starting materials.
The franchiser loses some incentives in starting such a system. Individual franchisees realize increased power over the franchiser.
Subfranchising
In this system the franchiser permits certain franchisees to sell new franchises and become subfranchisers who are responsible for training and development and entitled to collect royalties from the subfranchisees.
This system is great for quicker growth and requires fewer employees at headquarters. However, conflicts between the franchiser and subfranchisers may arise over such issues as the schedule of system development and the ability of subfranchisers to recruit new franchisees in a time frame desired by the franchiser. In addition, the franchiser loses some power because subfranchisers have a great deal more power than regular franchisees. Also, choosing new subfranchisers is difficult given the relatively small number of people with enough capital to become a subfranchiser.
TERRITORY DIVISIONS
Exclusivity is an important feature of territory formation. Although guaranteeing exclusive territory rights to franchisees usually results in a reduced amount of market saturation, it is still a great strategy to use for certain products or for new franchise systems. Statistics have shown that of the 170 new franchise systems begun in the 1990s, 91 percent of the surviving systems use exclusive territories.
As suggested by the concept of area development, exclusive territories cut down on the practice of some franchises, exploiting the advertising efforts of other franchises in the same area. In addition, franchisees with exclusive territory rights need not worry about excessive competition from other franchisees or the franchiser.
Exclusive territories are generally small. The franchiser wants to offer the benefits of exclusive territories without diminishing market saturation to such a degree that the franchise system as a whole suffers. Without enough franchises in the marketplace, competing franchises will gain a better position. Territories must be small enough to allow healthy competition while also sheltering franchisees against encroachment. Territories can be allotted based on population, wealth, or other demographic factors—not on an equality of geographic size.
RIGHT TO EXPAND
Whether or not franchisees have the right to expand their territories is a final factor that must be weighed and considered by a franchiser. Allowing expansion has many benefits. It gives franchisees a greater incentive to succeed and conform to the franchise system’s strategies and rules, making franchisees much easier to monitor. The incentive lies in the fact that most expansions are permitted based upon the success level of the franchisee. In addition, allowing franchisees to expand cuts costs for the franchiser because it costs less to expand than to open a new outlet. From the perspective of the franchisee, expansion eliminates fears of encroachment and makes saturation problems disappear because they are in control of all outlets within their territory.
EXPANDING YOUR OPERATIONS
For you, owning one franchise might be enough. On the other hand, you might be the kind of person who wants to own and run more than one outlet. In this chapter, you will find the information and guidance to help you determine whether you are cut out for multiple franchise ownership — legally, financially, and personally. I will also discuss the negative and positive aspects of owning more than one franchise.
CHECKING YOUR FRANCHISE AGREEMENT: CAN YOU BUY ANOTHER FRANCHISE?
Before you can own multiple units, you need to make sure that multi-unit ownership is permissible. If multi-unit ownership is an option, learn all you can about the restrictions governing it. You want to remain in compliance with your agreement at all times. This information might be included in the UFOC. If it is not, a simple query to your franchiser will provide all the information you need. Make sure to ask about franchise fees and royalties for multiple units. Fees will probably be lower for expansion units than for the original unit, but double check to be sure.
Transfers might be permitted, but your agreement may state that the franchiser has the right to reject proposed transfers. If your current location is not functioning up to the franchiser’s standards, a rejection is possible. In addition, the franchiser may have the right of first refusal for any franchise that comes onto the market.
UNDERSTANDING YOUR PURCHASE OPTIONS
If there are no restrictions on the establishment of an additional franchise, you will need to decide where, when, and how to set up shop. You will need to evaluate sites for your new franchise in the same way you did for your original franchise, considering traffic, demographics, lease terms, competition, and building costs.
Buying an Existing Franchise
You might have your eye on a neighbor’s business. Even if it seems as though the franchise is happy and successful, she might be ready to leave the business for any number of reasons. You will never know until you inquire. Communication with your fellow franchisees could alert you to businesses that will soon be for sale or that could be for sale if you express an interest.
You should learn about the sales status of existing franchises from your franchiser. Once they know about your plans to expand, they could suggest an existing franchise for you to take over or you can ask them about any that might be up for sale. Your franchiser might even sponsor an active resale network. They would rather see existing franchises taken over by willing owners than see them close completely.
The location you find to take over should be close enough to your original location that you can easily keep tabs on both, but far enough away to avoid competition with your current location. Figure out why the current owners are willing to sell. If they are selling for personal reasons, that is one thing, but if they are selling because there are problems with the store, you will need to address those problems and determine whether they can be solved.
Insist on seeing the performance statistics. Ask either your franchiser or the franchisee for operating figures and results. You should be able to analyze these numbers and decide whether the business will be profitable for you.
When considering the purchase of an existing franchise, you should answer the following questions:
• Does the current location meet the franchise system’s standards? One of the benefits of buying an existing franchise is that the equipment should already be there and the building itself should be ready to go. If the location is not quite up to par, weigh the expenses of improvements against the expense of building a new location and go from there.
• How profitable is the existing franchise? Can any problems be solved?
• Does the original franchise contract have enough years remaining on it to allow you to amortize your additional costs?
• Has the franchiser assigned the location good reviews in the past?
• What are the current employees like? Will they be willing to continue working at the location after a transfer of ownership? Can you resolve any current labor conflicts? Are the managers reliable and trustworthy? Will the managers at your current location be willing to transfer, if necessary?
• What does the public think about the location? If the public’s opinion is low, can steps be taken to regain trust and customers? Do current demographics of the area still match your target-customer profile or has the demographic landscape changed with time?
• What are the terms of the current lease and do they meet your interests?
• Are there existing legal problems that could affect you in the future?
• Does the location pass all standards you would set for a new location?
RETRO-FRANCHISING
Through retro-franchising you have the opportunity to buy a location directly from your franchiser. Many franchisers own and operate their own locations; some of these were set up for the long-term and others were set up with the intention of selling them to franchisees at a later date. Your franchiser may be willing to sell you a company-owned location for a number of reasons — to cut losses, expand markets, increase capital, or simply because the location was created just for that purpose.
At times a franchiser has an opportunity to purchase space that will serve as a great location in the future. For example, a new subway station might be built with room for a restaurant and a restaurant franchiser might purchase that slot with the intention of finding someone to run the location at a later date. These could present great opportunities for you, although many of these locations are nontraditional.
Franchisers take into account the concept of “critical mass” when considering whether to sell a location to a franchisee. Critical mass is simply the number of units deemed necessary to infiltrate a market area. Critical mass allows efficient advertising and increases brand recognition within these markets. Also, when an area reaches critical mass, the franchiser is able to provide better support for existing franchises by sending field agents out to more units at a lower total cost. Your franchiser may be willing to sell you a location to get closer to critical mass in a given market.
Retro-franchising is a great option because you will acquire a store that is already running and is up to standards. Franchisers will sometimes sell these units at a discounted price. My only caution to you is to beware of “churning,” a practice in which a franchiser will sell a location to a franchisee and then take it back with the intention of selling again, knowing that every franchisee is destined to fail at that location due to unavoidable problems. Check the history of any location you are considering retro-franchising.
CONVERTING A COMPETITOR’S LOCATION
If you would like to take over an existing establishment but cannot find any opportunities in your desired market within your own franchise system, you might want to consider taking over a competitor’s location. If you find a suitable location that meets your needs and is up for sale, you can expand your business and reduce your competition in one move.
Independent mom-and-pop businesses are finding it more difficult to compete with franchises in the same market. If you ask around, you might be able to purchase a location from one of these independents. Since you are operating in the same industry, you will benefit from an existing customer pool and, while employees will need to be trained, they may be willing to stay and work for you.
Taking over a competitor’s location will entail substantial remodeling. Zoning issues should not come into play. You will need to hire a contractor to complete any restructuring and you might need to invest in equipment that meets your franchise system’s standards. It costs less to remodel than to build a new location.
In certain situations, such as when extensive plumbing, electrical, or structural changes are required, it might be easier and cheaper to build a new location. You should check with your franchiser’s development department to determine the costs of each move.
You will also need to check with a lawyer to go over the franchise agreements of your franchiser and the franchiser of the original owner, if applicable. The original franchisee might have signed an agreement preventing the selling of the location to a competitor. You should also make sure that by purchasing the new location you are not violating the territorial rights of another franchisee within your system.
STARTING FROM SCRATCH
Do not forget that if you cannot locate a suitable existing location, you always have the option of starting from scratch and repeating the steps you took to select and prepare your first location.
BUYING MULTIPLE UNITS
Although some franchisees decide to expand after experiencing success with their first business, you might have purchased your franchise with the intent to expand right from the beginning. You are not alone. Many franchisees are part of an investor group looking to open up multiple locations and get an inside edge on a market. Some of these groups could even be larger and more powerful than the franchiser. After the purchase of a handful of units you will probably find that you need to establish your own management facilities to coordinate the management of all your units. You might also need to establish training centers in order to accommodate the constant influx of new employees. Managers will have greater responsibility and will need training similar to that provided to the franchisees.
Acquiring an Area
If you have your sights set on multiple ownership from the beginning, you should find out if your franchiser offers the right to develop an area. You can purchase this right and it will permit you to expand within a certain territory at an established rate (a certain number of units in a certain amount of time). Some franchise systems only allow expansion along this model. This way, the franchise systems minimize management and training needs, while simultaneously growing. Alternatively, your franchiser might offer area development expansion only within large, core markets; in smaller markets, your franchiser might only sell to individual franchisees who want to own one business.
Before you purchase area development rights, consider the following: 1) how many stores would you like to own?, 2) what is your financial situation and will you be able to support your desired number of units?, 3) will the area being offered for development be able to support your desired number of units?, and 4) what costs or savings will you see based on your decision to develop an area as opposed to over-purchasing additional units when they become available?
Do not enter into an area development agreement without substantial funds. You can expect to pay a huge up-front fee or a fee per franchise. Either way, the cost to you will most likely be large. You will, at the very least, be expected to pay the full franchise fee for the first unit along with a large percentage up-front deposit for each additional expected unit, with the remainder of the fee due upon the opening of each unit.
Keep in mind that if you do not end up opening the additional units, for whatever reason, you cannot necessarily expect your deposit back from the franchiser. You will also be expected to keep up with set development schedules. You should check on your franchiser’s default policy before investing in area development.
Although financial policies are often in place, many franchisers will adapt their responses to late development according to individual circumstances. A fee could be assessed or you might be granted a grace period. The franchiser will likely evaluate your degree of commitment to the project before determining the consequences of your default.
REVIEWING YOUR PERSONAL AND BUSINESS RESOURCES
After reading this chapter you might find yourself contemplating becoming a multi-unit owner. You need to perform some serious and honest personal and financial reflection before making any multi-unit commitments. When you add units, the entire structure and functioning of your business changes. You will find yourself operating on an entirely different scale. A good first bit of advice is to get your ideas, plans, and tactics out on paper. Often, the numbers, notes, and options you jot down will help you to visualize your situation more clearly and will help you to make the right decision.
Take Some Time for Personal Reflection
Along with multiple ownership comes more frequent and required relationships. Ask yourself if you are ready to be in charge of a large team.
Your responsibilities will increase dramatically. If you are currently struggling to get through the day — opening, operating, and closing up your business, while also maintaining a healthy personal life — then multiple ownership is not for you.
Imagine needing to manage the daily operations of two, three, or even 20 units! Alternatively, imagine managing the number of people it will take to oversee daily operations. If your personal life is too demanding, then multiple ownership is not right for you.
Because you cannot be everywhere at once, you will need to hire and manage reliable employees so that you can delegate authority. At the start of this new venture, you will focus on the new units, but eventually you will need to address the issues of all units. You will need to be able to entrust individual unit managers with many responsibilities.
You will need the organizational skills necessary to set up staff training and administration centers if you plan to operate more than a handful of units. These centers will need competent clerical, legal, and financial personnel.
Remember that the desire to expand is not enough. You must be personally capable of the expansion as well.
Take a Hard Look at Your Business and Finances
Before expanding, look at the current state of your finances and the health of your business. You did a lot of preparation before purchasing your first franchise unit. Did you prepare well? Did you make the right decisions? Before you purchase your next unit, think about the following.
• Are your employees ready to meet the demands an expansion will require? Look at your management. As a single store owner, you might be the general manager, with shift managers overseeing your employees directly. If you purchase additional units, you will need to manage all of the units as a whole and give more responsibility to your shift managers. Are they able to become general managers? Are your other employees ready for new responsibility and can you trust all your employees to operate the store without your constant presence?
• Before you invest time and money into expansion, take a look at the competitor landscape. If you are having problems keeping up with your competitors and want to expand to get a leg up, make sure they do not also have expansion plans. It would be a bad move to expand only to be shut down by a similar move by the competition.
• How will expansion affect your customer base? Will the loss of a personal touch be felt by loyal customers or will expansion fit the needs of more customers in other ways?
• Do you have the finances to expand? What fees and other costs will you be expected to pay in addition to the funds needed to open the new unit?
Crunching the Numbers
Whatever you do, you do not want the opening of a new unit to damage the success of a current unit. Examine your financial picture to ensure that no damage will happen. Use your up-to-date balance sheets, investment portfolios, budgets, profit-and-loss statements, and cash flow analyses to make sure there are current sources of funding for the new unit. You might be able to make the numbers work by seeking out additional financing, perhaps even from your franchiser. Do not overburden yourself with debt to the point that both units suffer. Rates or loan policies may have changed since you took out the loan for your original unit. Costs of construction, licensure, or real estate may also have changed. Changing franchise agreements can make your start-up costs higher than they were originally, despite the possibility of a reduced franchise fee for multiple ownership. Make sure you do your calculations based on current rates.
Do not forget that with more units to stock and maintain you will be purchasing more supplies. You may be able to get supplies at better cost through volume purchasing. Financial burdens as well as blessings should be taken into account when determining if you are financially ready to expand.
Finally, it is highly recommended that you turn to your legal, financial, and marketing professionals before committing to any expansion plans. They may provide you with insights that you missed during your own review. They may also be able to provide you with useful tips and advice. Discuss any plans with your franchiser’s development staff as well.
THE PROS AND CONS OF MULTIPLE OWNERSHIP
If you find yourself looking in the mirror in the morning thinking what a great guy or gal you are for being such a success; if your bank, franchiser, accountant, employees, and community all love you and congratulate you on a job well done; if you are planning to kick back and enjoy that dream vacation to Maui; if you are even planning on cashing in by opening more units — STOP! Do not think that your success as an individual franchise owner will carry over to multiple franchises. Multiple ownership has its pros and cons. I discuss these in this section. Weigh them carefully.
Pros
Opening more units can bring you more money. You will be building equity in your businesses and in any real estate you purchase for your businesses. More units can mean cheaper costs in terms of supplies and employee benefits. You can receive better rates when you apply for loans and other financing.
Additional units also make the cost of marketing more palatable. You might have difficulty justifying the high cost of radio or television advertising for one unit, but when you are paying to promote multiple units, the advantages easily outweigh the costs. More media exposure means more customers.
The larger your operations within a particular market, the more qualified employees you will attract. You will have the capability to offer more career development opportunities and employees will have an easier time imagining such opportunities. You will no longer need to turn away as many qualified applicants because you will have more positions to fill. You will also be able to transfer staff from unit to unit, as need dictates, within the same market, allowing you and your employees much greater flexibility.
If pricing is not determined by your franchiser, you will be able to standardize pricing on identical products within your market (as opposed to having customers notice price differences between individually owned franchise units within the same area), leading to greater customer satisfaction by cutting down on confusion.
Cons
If you are not personally and financially prepared, opening multiple units can ruin your successful original unit. You will need the leadership, management skills, and capital to run multiple businesses. For some the old saying, “If it ain’t broke, don’t fix it,” might apply. If you are not ready to expand and you do it anyway, you could ruin a good thing.
Your success as a multi-unit owner may cause you to discover problems and flaws with the organization and practices of the franchise system and you may be tempted to institute your own changes within your units — but you cannot. You must remember that no matter how large you grow, you are still a franchisee and there are still rules to follow. You can easily turn these negatives into positives with the right thinking and the right approach.
FRANCHISING ADVANTAGES AND DISADVANTAGES
If you have a business you are thinking of franchising, this section is important. In it we will discuss the advantages and disadvantages of the franchise model. You should use this section to help decide whether franchising your own business is a step you should take.
When you own a business, one of the most important decisions you will need to make is how to organize management. Sole proprietorships give you all the control and changes can be implemented in the blink of an eye. However, you may lack the range of talent that larger management systems can provide.
Large corporations have the necessary talent, but change is difficult and takes time. Pyramid-shaped organizations function well at the top, but at the bottom levels you will often find that the organization is no longer in touch with its customer base. The lesson learned? No matter what organization you use for your company, it will have advantages and disadvantages. The key is to decide which organization is best suited to your company and which will give you the advantages you most need within your industry. One of the methods of organization to consider is franchising. It too has advantages and disadvantages.
ADVANTAGES
There are four basic advantages to the franchise model:
1. You take on a relatively low amount of risk for your financial returns.
2. Each store will realize better incentives for success.
3. You will be able to attract better management talent.
4. You will experience an increased rate of growth over other models.
I discuss each of these benefits in the following sections.
Low Risk for Financial Returns
In franchising you are distributing risk among the various franchisees rather than holding all the cards in your own hand. Any failed expansions or failed efforts for improvement are funded from the franchisees’ pockets, not yours. You, as the franchiser, will also be able to assume more risk than otherwise possible. If you owned each outlet, you would want to have a very high chance of success at a particular location before paying to build a unit there. By franchising, this risk is partly assumed by the franchisee and thus locations that are less than optimal can be developed for potential use.
Better Incentives for Success At The Unit Level
The best way to understand this benefit is to imagine the differences in managerial style between two managers, one corporate, one a franchisee. Imagine that Manager A works at a company-owned store with about $800,000 in sales per year. Manager A receives a salary of $55,000 plus the possibility of a bonus, which is based upon his sales and his ability to operate under budget. Most years, he does not get a bonus. Manager B, on the other hand, is a franchisee. Her store also does around $800,000 in sales annually.
Rather than earning a set salary, Manager B takes the profit of the store minus expenses and royalty payments. At the end of the year she ends up taking home about the same amount as Manager A: $55,000.
Suppose both managers learn about a new food handling technique which, if implemented properly, will cut costs by about $10,000. The only cost to them will be about ten hours of their time, required to train employees in this new procedure. If the managers decide to undertake the training, Manager A, because of his bonus, will earn an extra $2,000, while Manager B will take home the extra $10,000 she saved in expenses.
In addition, Manager A will get the added personal profit (the bonus) in the first year only (the new operating costs become his baseline in following years). Manager B, on the other hand, will appreciate the $10,000 profit every year to follow as part of her personal take. Imagine if Manager A gets no bonus for cutting costs — he would have no incentive to spend ten hours of his time trying to save the company $10,000 a year.
Put simply, owners have more of a stake in a business than employees. In company-owned stores, managers are just employees after all. In a franchise, on the other hand, the manager is often the owner and will have a much greater interest in cutting costs, increasing sales, and seeing the business succeed and turn a profit.
Attract Better Management Talent
Why can a franchiser attract better management talent than ordinary corporations? Quite simply, because franchising requires a large financial investment on the part of the franchisee.
Investing in a franchise can cost hundreds of thousands of dollars. Most people able to finance such an investment will be responsible and hard-working and have business savvy. Anyone who makes that kind of investment will have more of an incentive to see the investment pay off.
While corporate positions typically have flat salaries, franchise managers see profit based upon their own hard work and efforts. Profit based upon effort is more appealing to managers with expertise and know-how because they are aware of their work ethic and ability to get results.
More Rapid Growth
A lack of capital will decrease growth and an excess of capital will allow more rapid expansion. In the franchise system, capital comes from individual franchisees rather than from the parent company. The franchise system is unique in that, during times of growth, the franchiser will see more capital arriving from royalty payments and franchise fees, while the cost of setting up new units is borne mostly by franchisees. The advantages to the franchiser are enormous and are the primary reason why the franchising system was developed in the first place.
If your company is relatively new, it might be more difficult for you to secure funding for expansion from a bank or other source. Without an extensive track record, banks will be hesitant to loan you large sums of money, even assuming that the market for your product is good. Franchising is a great solution to this problem as the money needed for expansion is supplied by franchisees. Franchisees are usually more willing to invest in a new company— they have the time and incentive to do the extensive research needed to determine whether the business is bound for success or failure. Banks do a more cursory examination when they determine investment risk.
DISADVANTAGES
There are four major disadvantages to franchising. They are as follows:
1. Your goals as a franchiser might differ from the goals of your franchisees.
2. Large franchise systems resist change.
3. Your returns as a franchiser will tend to be lower than if you owned all the units directly.
4. You will see higher costs of doing business.
These are discussed in more detail in the following sections.
Different Goals
Although the primary goal of a franchisee is to realize maximum profit (which will increase personal earnings), franchisers are more interested in increasing sales, which will increase their revenue because of higher royalty payments. These goals involve different sales strategies. Franchisees will be looking for business that will decrease costs and time, while franchisers will want more business at every turn.
Coupon promotions started by the franchiser illustrate this conflict well. Coupons that offer products for free or at reduced prices draw in customers. While the franchiser will benefit from coupons because more products are being sold, increasing royalty payments, the franchisee will not see profit from free or reduced-price products, which will decrease their bottom line.
Conflict often arises during expansions. Franchisers want new stores to open because they receive large franchise fees and more royalty payments. Franchisees see additional properties close by as threats — new stores can draw customers away from their own stores.
While it is in the franchiser’s best interest to keep franchisees happy and franchised units doing well, there is always a give and take between franchiser and franchisee. This give and take can complicate the running of your business.
Resistance to Change
A franchise system is comprised of dozens or even hundreds of owners with individual agendas and goals. Trying to introduce change into the system can be difficult. The franchiser wants to avoid coercion at all costs. Trying to win mass approval for a change is not an easy task. The franchiser must be aware of legal issues preventing the preferential treatment of one franchisee over another. Although regular corporations can change processes or products at one or more stores for experimental purposes, the franchiser cannot make such changes without consent from the franchisee. Any change to be implemented must be negotiated and renegotiated with each and every contracted franchisee, resulting in high costs for very small changes.
As a franchiser, you may not be in touch with the market trends that trigger changes necessary to keep up with changing times. Most change in corporations is in response to shifts in the market or consumer trends; these corporations actively collect data to spot such shifts. In the franchise model, this data would have to be collected from franchisees. Collecting such data would be expensive, time-consuming, and not directly profitable to the franchisee. As a result, the franchiser can expect poor analyses, if any.
Because of the high unit-level costs of introducing new products and services, franchisees are often reluctant to sell new products until the products have a proven track record. Franchisees have to spend time and money in training, signage, promotion, and inventory to introduce a new product. They will be unwilling to do so if they are not confident that the product will be a success.
Lower Returns
In setting up a franchise system you will be faced with a number of high costs. The first such cost is setting up the system itself. Because of the necessary legal and financial advice, the cost of training materials, brochures, UFOCs, and start-up resources for each potential franchise, setting up the system can cost hundreds of thousands of dollars.
Although the capital necessary to expand will be lower, profits generated at the unit level will revert to the franchisee. Research suggests that, on average, the franchiser can expect to see $1 per every $3 of profit at the unit level. The other $2 goes into the pocket of the franchisee. In addition, technological changes that will improve efficiency at the unit level will tend to benefit the franchisee and not the franchiser. The only thing that will benefit the franchiser is increased sales (because they result in higher royalties).
Higher Costs of Doing Business
There are several costs associated with the franchise model that are an inherent part of the model and cannot be avoided. These costs are due to the nature of the relationship of franchise units to one another.
There is the “free rider” problem. The costs of a negative action by one unit are borne by all units and the cost of a positive action is borne by one member but benefits all members. If one unit of a well-known franchise is sued for discrimination, the negative publicity generated by that unit’s actions will tend to reduce sales across the same system. If one unit of a well-known franchise pays for a large billboard advertisement, other units in the area benefit from the advertisement without paying a dime in advertising fees. Such a free rider situation can have profound effects on all units and can add costs otherwise unexpected at the unit level. It can also lead to hostility between unit owners. The free rider phenomenon can be partly overcome if the franchiser imposes quality and service requirements on the franchisees. Creating a list of approved vendors also helps. These actions also incur costs to the franchiser.
Another example of the higher costs of doing business involves protecting confidential information. Reflect on your business for a moment: Do you have any trade secrets, secret recipes, or intellectual property that must be protected from common knowledge for your business to succeed? If so, you will have to pay substantially to protect these secrets. You will have to entrust some amount of knowledge to your franchisees, but for full protection you will need to employ the aid of professionals who can set up elaborate ways to protect your information. You will need to hire legal professionals to create nondisclosure agreements and the like. Costs for these protections are particularly galling because there is no guarantee that your efforts will protect confidential information, and yet, they are necessary costs.
FRANCHISING AND THE LAW
Franchise systems are legally regulated. If you are thinking of franchising your business, you must be aware of the various legal obligations by which you, as a franchiser, will need to abide. In this chapter we will outline some important legal issues. Franchise regulations will be discussed according to both state and federal laws and some pros and cons of operating within various state frameworks will be analyzed.
FEDERAL LAW
Franchisers are required by the Federal Trade Commission to provide certain information to prospective franchisees, including details of the history, operations, and governing principles of the company. This information is contained in the UFOC and must be provided at least ten days in advance of any signing. However, franchisers selling to overseas franchisees or to franchisees meeting the criteria of “sophistication” do not need to provide this document. The FTC has created a standard UFOC template, which it provides to franchisers. This table lists items required for disclosure in a UFOC document.
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ITEMS REQUIRED FOR DISCLOSURE IN A UFOC |
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1. |
The franchiser and predecessors |
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2. |
Business experience of persons affiliated with the franchiser |
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3. |
Litigation history |
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4. |
Bankruptcy history |
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5. |
Initial fee |
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6. |
Other fees |
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7. |
Initial investment |
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8. |
Restrictions of franchisee sourcing |
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9. |
Franchisee’s obligations |
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10. |
Financing |
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11. |
Franchiser’s obligations |
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12. |
Territory |
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13. |
Trademarks and service marks |
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14. |
Patents and copyrights |
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15. |
Obligation of the franchisee to participate in the business |
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16. |
Restrictions on franchisee sale of goods and services |
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17. |
Renewal and termination |
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18. |
Arrangements with public figures |
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19. |
Earnings claims |
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20. |
Statistics on system |
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21. |
Audited financial statements |
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22. |
Contracts |
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23. |
Acknowledgment of receipt |
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Compliance with the UFOC requires an audited financial statement, driving up franchise expenses significantly because of hiring both the auditing firm and an experienced franchise attorney. Furthermore, if you make claims about franchisee earnings from your outlets, you need to provide additional disclosure about those earnings. |
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STATE LAW
State laws often govern two key aspects of franchising. First, state regulations may dictate what can and cannot be done by franchisers to sell franchises and may include restrictions concerning registration of the company and the provision of information to potential franchisees. Second, state laws may govern the relationship between franchisers and franchisees, including issues such as the termination of a franchise agreement.
Not every state has franchise laws; some states only have laws governing the first aspect of franchising and some only the second. There are large differences between franchise laws from state to state. Consult a legal professional about state laws. It is important to be acquainted with your own state’s laws, as well as the laws of the states in which you have operating franchises.
Registration States
In states requiring the registration of franchised companies, franchisers must furnish state regulatory agencies with a UFOC before starting any franchising activity. In most states you can provide the same version as you gave the FTC; California, Indiana, Maryland, Minnesota, Rhode Island, South Dakota, Virginia, and the District of Columbia require different versions. Registration states also require you to file annual, sometimes quarterly, reports containing specific information. Recently, registration has been simplified by an electronic registration system that allows franchisers to register with all registration states simultaneously.
Why do states require registration? First, the theory is that if they are required to register, franchisers will be more likely to provide accurate information to franchisees. Second, franchisees are afforded some level of protection through the registration process: Fees might be required to be put into an escrow account; bonds could be issued protecting franchisees from an under-capitalization of the franchiser; and any performance claims made by the franchiser to attract potential franchisees can be more easily verified.
As a franchiser, you must document any changes made to your franchise system and you must provide updated versions of your UFOC to registration states. Things that must be documented include changes to your fee schedule, franchisee obligations, or the legal structure of the company; updated financial information; or any programs added or modified concerning your interaction with franchisees. It is in your interest to minimize negotiations with franchisees and to offer standardized agreements to all franchisees to avoid re-filing the UFOC frequently.
Because of the large regulatory burden, you may decide to avoid operating in registration states altogether, as do almost 50 percent of existing franchised organizations. By operating in registration states, however, you receive a number of benefits. Some estimates show that the oversight system provided by registration states has made companies operating in registration states 22 percent more successful on average. Also, franchisee confidence is bolstered by your willingness to comply with state regulations; they take it as a sign you are on the up-and-up. Finally, the larger your company, the cheaper it is to operate in registration states; conversely, the larger your company, the more expensive operating outside of registration states becomes.
Relationship States
Relationship laws are typically put into place to protect franchisees. The laws make sure that franchisers provide an acceptable reason for contract breaches such as termination.
Relationship laws give franchisees a way to fight any contract breaches by the franchiser. Such protections also raise franchiser costs, causing many of them to demand higher royalty payments from units located within relationship states.
Franchisees will be more willing to take on a unit with your franchise if you operate in relationship states. Relationship laws simply make franchisees more comfortable in their investment. At the same time, relationship laws make getting rid of ineffective or problem franchisees difficult. This table lists states with different relationship provisions.
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STATES WITH DIFFERENT RELATIONSHIP PROVISIONS |
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States That Require Cause for Termination |
States That Allow Cure in Termination |
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Arkansas |
Arkansas |
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California |
California |
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Connecticut |
Hawaii |
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Delaware |
Illinois |
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Hawaii |
Michigan |
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Illinois |
Minnesota |
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Indiana |
Washington |
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Michigan |
Wisconsin |
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Minnesota |
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Nebraska |
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New Jersey |
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Virginia |
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Washington |
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Wisconsin |
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FRANCHISER CERTIFICATION
Getting your franchise certified will win you respect and trust from potential franchisees. Through winning contests or being ranked by media outlets, you will gain recognition and much-desired notice. Recognition by any reputable medium, be it a magazine, newspaper, or some other organization, will benefit your company more than you can imagine.
You should apply for membership in important trade associations such as the International Franchise Association. Membership is not a given: Only about 600 of 2,500 existing franchises are members. To be a member, you must be able to demonstrate higher than normal standards, that you have no legal violations on record, and that you operate in compliance with all state and federal regulations. Membership is a sign of quality, reliability, and profitability.