Wednesday, February 22, 2006

Should You Buy a Franchise?

This episode features an excerpt from the Nolo book “How to Run a Thriving Business: Strategies for Success and Satisfaction,” by Attorney Ralph Warner.

Should You Buy a Franchise?

Almost every franchise presentation emphasizes that nation-wide franchise businesses take in about 50% of the retail sales dollar. What isn’t said is that the great majority of these dollars come from just a few categories: automobiles, gasoline, lodging, and fast food. Beyond these mega-buck fields, only a small percent of the money retailers take in goes to franchised operations.

Some Exceptions to the Rule:

Although I’ve become convinced that sinking money in a franchise is generally a bad investment, and no way to get your start in business, let me start with a couple of exceptions to my own rule. The first exception involves franchises built around continent-spanning communications networks, such as national hotel and motel groups, which maintain 800 phone numbers, and web sites allowing travelers to easily book reservations. This is not to say, of course, that any particular hotel, motel, or auto rental franchise is a good deal, only that, unlike many other franchises, they do sell something of real value. Second, franchises with brands that really are famous and highly regarded can sometimes be worth the high cost. Franchisees, especially those who bought in years ago at good locations, have made big profits in McDonald’s, Pizza Hut, Motel 6, and other world-famous franchises. But it’s been decades since an ordinary person could afford to purchase and build out one of the relatively few guilt-edged franchises.

The High Cost of Franchising

The biggest problem with many, if not most, franchises is depressingly simple: they charge too much for a business that doesn’t have enough value to justify the high upfront and ongoing costs. To help understand why this is true, answer these three simple questions: how hard is it to make a sandwich? How hard is it to clean a house? How hard is it to put grout in tile? If your answer is “not very,” then I have another question for you: why pay a franchise operator a large sum to teach you how to do one of these or other simple tasks, when you could learn to do it on your own for far less?

How Much Will You Have to Pay?

First, you’ll pay an upfront franchise fee, which might be $30,000 to $70,000 or more, for a little known housecleaning service. Typically, you’ll also be required to pay the franchise 3-6% of your monthly gross revenue. Big name fast food operators such as Wendy’s, McDonald’s, Burger King, and Subway, typically charge between 8% and 11%, plus a few cents on the dollar for a franchiser’s marketing effort. Put these fees together and it means that in addition to paying the upfront fee for the franchise, you’ll usually have to pay the franchiser six to ten cents or more of every dollar of revenue, and if the franchiser requires that you buy goods or services either directly from it, or from an approved supplier, your costs will probably be higher, because franchisers commonly charge substantially more than do suppliers on the open market. Let’s assume that the extra cost would amount to two cents out of every dollar of revenue. Add it all up, and you’ll likely pay the franchiser ten cents of every dollar you take in. This is a huge burden to your long-term profitability.

But Won’t a High Volume of Sales Compensate for These Costs?

Consider that the entire profit margin of many small businesses is less than ten cents on the dollar, and few businesses do much better. And, of course, your franchise fees don’t get your business open. If you want to open a business that has a high startup cost, such as a restaurant, you’ll need to build or remodel a physical space, purchase equipment, and train employees, things that are usually more expensive when you must conform to a franchiser’s many specifications. But if you don’t get a leg up from a franchiser, how will you get the knowledge and skills you need to open a successful business? Chances are, you can learn on your own for free. For example, if you’re interested in opening a lock shop, nail salon, or coffee shop, get a job in one for a few months, instead of buying a franchise. Not only will you learn much about how the business works, but you’ll be paid to do it.

But What About All the Benefits of the Franchiser’s Marketing Efforts?

National franchise outfits rarely do a good job of promoting their local franchises, in part because they typically rely on broadcast and print media campaigns, which for small businesses are usually an inefficient way to use precious marketing resources. Even worse, because franchisers are usually headquartered outside a franchisee’s area, they’re not equipped to implement the many types of low-cost local marketing that can be extremely effective.

But Won’t the Franchiser teach me How to Run My Business?

Of course, to many prospective purchasers, the big appeal of buying a franchise is that someone else has figured out how to run the business. Just pay your money, and the franchiser will explain in great detail exactly how to make a donut, or wash a car, or sell sneakers. Often overlooked is the fact that operating a business by following an instruction manual can also be a big negative. Instead of having a chance to exercise your creativity and imagination to improve and change your products and services, you’ll be sentenced to endlessly repeating someone else’s recipe. Some people think they won’t mind running a boring, uncreative business, as long as it’s solidly profitable. Well, maybe. But the truth is that you are limited from actively using your intelligence and creativity to adjust the business to fit local circumstances, or take advantage of what you learn, which is almost sure to make the business less likely to succeed.

Watch Out for Franchise Contracts

Another reason to avoid a franchise is that franchise contracts are stacked against you. These contracts, which typically run fifty pages or more, are written and rewritten by skilled lawyers, to be sure the franchiser remains firmly in control of the relationship. Like buying a car or an insurance policy, you have no chance to negotiate a change to even one word of these agreements, which by itself should tell you all you need to know about the one-sided nature of your future relationship. Here are just a few of the ways the fine print of these contracts benefit the franchiser:

You Can’t Compete.

Should you wish to close a franchise and open a similar independent business, you’re typically prohibited from doing so for at least three to five years.

You’ll Need Approval to Sell the Franchise

To sell your franchise sometime in the future, you’ll probably have to get the franchiser’s approval. Not only can this make the sales process more difficult -- the franchiser might reject a purchaser you consider well-qualified -- but it means the prospective purchaser will have to agree to the terms in the then-current franchise contract.

You’ll Have to Travel to the Franchiser’s Home State for Legal Disputes

If you get into a legal dispute with a franchiser, the franchiser may require that you file your lawsuit on the opposite side of the country, and be subject to the law of the state whose courts are most favorable to the franchiser.

You Must Buy Goods and Services From the Franchiser

And, of course, the contract may require that you buy supplies, goods, and even services, such as marketing and advertising services, from the franchiser. Although this sometimes make sense – all chicken sold at Big Ben’s Bird House should look and taste the same – often it’s just another way that franchisers take money away from franchisees.

How do you evaluate a Franchise?

Well, despite my anti-franchise arguments, you may remain convinced that a particular franchise really does have such a valuable name and reputation that buying in might be a good deal. If that’s so, I recommend you go through the following steps:

Step 1: Get the Franchise Circular

Before you do anything else, ask the franchiser for a copy of its Uniform Franchise Offering Circular (UFOC), a federally mandated document that contains loads of information about the franchise company’s history, operations, franchise network, rules, and costs.

Step 2: Talk to Franchisees

If you talk to a number of people who already own a franchise in the outfit you’re attracted to, I can virtually guarantee you’ll learn many interesting things the salespeople somehow never told you. Check out the list of franchisees who have left the system in the last year, and call some of these people. If the franchiser suggests that you talk to particular franchisees, don’t bother. One way or another, these people are part of the franchiser’s sales team, and are unlikely to give you fully objective information.

Step 3: Look at All the Costs

Carefully study sections five and six of the UFOC for answers to these questions: how much is the upfront franchise fee? How much money do you have to pay the franchiser by way of a monthly fee, often called a royalty? Is there an additional marketing or advertising fee? Are there other fees, for such things as travel, training, audits, and attorneys? How much will it cost you to actually get into business – that is, to construct a building or buy equipment?

Step 4: Find Out About Recent Lawsuits Against the Franchiser

You’ll want to know whether any unhappy franchisees have sued the company recently. Any such lawsuits should be listed near the beginning of the UFOC. If you find a history of litigation, contact the people involved to get their side of the story.

Step 5: Check Out the Competition

Open the phone book, and count the competitors in the particular market niche. In any popular field, chances are there will be a number of other competing franchise operations, as well as many independents. Do the franchise operators really have an advantage over the well-run independents?

Step 6: Analyze Your Options.

Finally, compare the cost of a franchise to the cost of opening and operating a similar independent business for a year. If, for example, you’d save $50,000 by operating independently, pretend you invest this money in United States bonds, and leave it there until you retire. Obviously, it makes sense to invest in the franchise only if you are pretty sure you would earn more than you would take in running an independent business plus your annual investment income.

The material you have just heard is excerpted from the Nolo book, “How to Run a Thriving Business: Strategies for Success and Satisfaction,” by Attorney Ralph Warner.

Copyright by Nolo. For over thirty years, Nolo has published reliable plain English books, software, and forms. Check it out at

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