By Michael Seid, Managing Director, MSA Worldwide
A better title for this article might be “Top Ten Reasons to Invest in a Well-Designed and Managed Franchise System,” because not every franchise system is built for success. As with any business, some franchise investments will be hugely successful, some will be outright failures, and there are those that will fall somewhere in the middle.
Whether or not a franchisor is rapidly growing is not really an indication of whether or not you will be successful as their franchisee.
The best predictor of your success in a mature franchise system is not how quickly the system is growing, but the performance of the existing franchisees in the system, and how frequently and under what circumstances the franchised units are turning over. In my workbook “Making the Franchise Decision,” which you can download for free from the Resources section of the MSA Worldwide website, you will find due diligence questions I would ask if I was considering investing in a franchise today.
With emerging franchisors prediction of success can be a bit trickier, as the number of locations open for sufficient time to predict success may be limited and the franchisor’s promise of having a “proven system” possibly just a bit premature. While the underlying units they had to base the franchise system on may have been successful, the franchisor may be expanding into new territory where their brand is unknown and untested, and the franchisor may still be learning the craft of being a franchisor.
Sometimes, a franchise system has been developed by a franchise packager, a broker, or on “norms” as seen through the franchise lawyer’s legal lens, and may not have been based upon a detailed analysis and strategic process. Package or cookie-cutter franchise systems that have not taken care to design a system that can support franchisees and expand their opportunities intelligently are risky investments for both the franchisor and franchisees.
Still, based on my experience, your opportunity for success in a well-managed and designed franchise system is extremely good, even if the franchise system is relatively new. It is up to you, however, to pick through the opportunities carefully and select a franchise based not on the emotions of the buy, but on careful analysis of the opportunity, the background and prior success of its management, its financial capabilities, and then only after conducting a thorough and supported due diligence. Focus a lot of your attention on the background and experience of the franchisor’s management team: past success is an indicator of how well they will shepherd the system you are joining. You are going to be in the system for many years, and you want to be certain that your franchisor’s management team is focusing the system’s resources on your success.
Let’s look at my top ten reasons for becoming a franchisee, but make sure to read more than the titles. My top ten list includes as many cautions as it does reasons why I am such a supporter of franchising.
Just like every stock investment needs to be evaluated before becoming a shareholder, franchising requires that you explore its potential benefits with open eyes and a consideration that it may not be the right path for you and your family.
Reason 1: As an entrepreneur you will be working for yourself
If you are truly an entrepreneur, you should never invest in a franchise. While franchisees own their own businesses, are not employees of the franchisor, are at risk for their capital invested in the business, and manage and operate the business on a day-day-basis, franchisees are not really entrepreneurs. While they may think of themselves as risk takers, franchisees operate under a license to use someone else’s brand and do so under someone else’s brand standards. A true entrepreneur is someone who needs to make their own decisions and chart their own course.
In a franchise system you will be obligated to follow someone else’s direction and agree to meet their brand standards – not set your own. As a franchisee you are really an “entrepreneur lite.”
Still, you will have achieved the American Dream of owning your own business; you will be rewarded for your own direct effort and business acumen; and when your business is profitable, those profits are yours and not your employer’s. So long as you are profitable and remain in compliance with the terms of the Franchise Agreement, no one is going to be able to fire you, and you may even choose to open additional locations, but with the permission of the franchisor. Understand also that if your business is not profitable, the losses are yours and your franchisor will not be sharing in your failure. Also, if during the term you stray far from your contractual obligations to the franchisor, you may be subject to default and potentially termination. With business ownership comes the possibility of success, but also the risk of loss. In franchising, some of the controls you have in localizing your business as you deem appropriate may not be available to you. You are part of a system, and each franchisee in the system benefits from a consistent level of product and services – and are also relying on you to perform well to brand standards.
Understand that you don’t own the franchisor’s brand; you are leasing it for a set period of time and unless they choose to extend that time, your franchise with them will end. You will not be earning any equity or ownership in the franchisor’s intellectual property just because you are using their brand, even if your business is highly successful. When the term of the agreement and any renewal periods expire, what you have left is your equity in the fixed assets you purchased for the business, and there may not be any other equity to sell or transfer to your children. It is essential that you understand clearly your rights and obligations as a franchisee and understand what your investment includes and does not include. Being an independent entrepreneur is not part of the bargain.
Reason 2: You are investing in a proven system
This may be true. In a mature, well-designed and managed franchise system there will usually be a proven system to provide you with the experience of the franchise, and that can give you the expertise you need to operate the business to the franchisor’s brand standards. Great franchisors have well-crafted initial and continuing training to provide you with that expertise. But not every franchisor has a proven concept and system, an experienced management team, or the ability provide you with the training and support you would expect from a proven system.
One of the benefits of franchising and pre-sale disclosure is that you can determine in advance what you are getting before you make the investment. But you need to invest the time and resources in conducting a proper due diligence. The Franchise Disclosure Document (FDD) will provide you with the contact information of current and former franchisees, and that gives you the opportunity to test the franchisor’s proven system claims by speaking directly to those current and past franchisees.
Some franchisees that have not been successful in their business blame franchising for their failure. You will find their posts on various websites. For the most part, even if they were the best operators of their businesses, had they done a proper due diligence, they would have chosen another opportunity. Remember, you are not investing in the emotion of becoming a business owner – you are investing in a franchise system and want one that is able to support you and one that meets the promise of having a proven system. Take the time to explore the brands you are interested in and determine how proven and successful their system really is.
Reason 3: The franchisor has brand recognition
Some do. Some don’t. Franchisors are licensing to you their intellectual property, including their brand, and when they have consumer recognition it enables you to open your doors with customers immediately. Franchisors invest significantly in marketing their brands to the retail customer, and this can afford you the possibility of immediate foot traffic, assuming the consumer likes the franchisor’s brand.
For emerging franchisors, or for franchisors whose brand is new to your market and your potential customers do not know of the brand, you need to recognize that you will be investing your own money in developing the brand equity that the franchisor has marketed to you as a benefit of their system. Where the franchisor’s product or service is new and innovative, you may also have to invest in introducing that new and innovative product and service to consumers and in doing so create the consumer demand the franchisor has also marketed to you as a benefit of the system. Being the first with a hot brand and product to any market can be an exceptional opportunity and one you should look for. Just have a rational understanding of what the franchisor is really providing and what you will need to do differently than in their other markets where the brand and the products and services are better known.
How the franchisor expands is also important to you. Many new or even mature franchisors allow the telephone to define their market expansion strategy. Some use nationwide brokers to market their franchises, and between the telephone and the brokers may not have a well-defined expansion plan. When this occurs, critical mass is not sufficiently established in any market to build significant brand recognition and many franchisors don’t have the resources necessary to support franchisees in every corner of the country, as they should if that is where their locations have been established. However, where franchisors are disciplined and build their market development strategy intelligently, in addition to creating brand awareness there are significant other benefits for the franchisor and the franchisee, including but not limited to support, marketing, a proper supply chain for products, etc.
It is often far better to be part of a strong regional franchisor than to join a franchisor with the same number of units scattered all over the country.
Reason 4: The franchisor has made mistakes that you don’t have to
Every business makes mistakes when first starting out. They picked the wrong location, needed to change the products or services or pricing, didn’t understand the business cycles, advertised too much or too little, ran out of product when they needed it the most, had too much product on hand at other times, didn’t understand the cash flow of the business, underestimated the initial investment, overstaffed or understaffed for the day or month or holiday, etc. They made mistakes, survived and learned, and now they are offering you an opportunity to join their system. There are a thousand different mistakes that you are assuming the franchisor has survived so that you don’t have to make them as a franchisee. That is the benefit of joining a mature, well-structured franchise program managed by experienced franchise executives. It is unrealistic to assume that an emerging franchisor can also deliver the same level of expertise and experience.
Franchisors that have been in business long enough to have made mistakes and survived have generally found the right formula for helping franchisees to avoid the same mistakes. If the only thing you got from a franchisor was helping you avoid those mistakes, that alone might be worth the cost of admission into the franchise system. Providing you with just the knowledge of how much capital you will need to start your business and then survive through break-even is of immense value, as not having sufficient capital is likely the number one reason small businesses fail.
Mature, well-managed franchise systems that communicate with their franchisees and review franchisee performance will have that type of information in spades. Those franchisors will often have robust Franchise Performance Disclosures in their offering materials. Emerging franchisors may also have much of that information as well, if they have operated their own locations in several markets for a reasonable period of time and have opened locations recently enough to make their start-up information valid and current. The franchisor’s Financial Performance Representation (FPR) is not an end product, as it is merely your starting place to develop your own budgets.
Reason 5: Initial and Ongoing Support
Franchisors routinely provide initial and ongoing training to franchisees, site selection and development assistance, and ongoing headquarters and field support. Franchisors generally have a team of experienced professionals to help you get your business started and support you during your term. In emerging franchisors your team may be the founder of the franchise system alone. That may be fine, since the emerging franchisor will often be more focused on making sure you are successful because your success will allow their franchise system to grow.
As with all other benefits, the initial and ongoing support is only as good as the professional employed by your franchisor, the effort they put into supporting you, and the quality of the underlying franchise system. In a mature franchise system you should consult with existing and former franchisees to determine the actual quality and benefit of the franchisor’s support programs. In emerging franchisors you need to understand what the real capabilities of the franchisor are. You need them focused on you and not necessarily focused on the original location they used as a model for your business. Emerging franchisors need to transition from being operators of a location into being franchisors early in their franchising process.
It is important for you to also determine where the franchisor is focused. If most of their staff is focused on recruiting new franchisees or taking the franchise system into international markets, you should not be impressed by the franchisor’s domestic or international growth. That is not directly helping you. You should be looking for the franchisor to be focused on supporting you and your sustainability.
In their marketing, many franchisors emphasis the supply chain benefits of becoming a franchisee. Lower prices for equipment and inventory are an attractive reason for becoming a franchisee. Understand that mature franchisors are likely better able to deliver on that promise than emerging franchisors. Take some care and examine the promises made by the franchisor regarding their supply chain. Just because a franchisor may have the ability to leverage the buying power of the franchise system to give you lower costs, does not mean that they will do so. In some franchise systems the supply chain is a material benefit to the franchisees, and in others it is a major source of revenue for the franchisor. Understand the franchisor’s focus in this area, as your cost of goods will impact directly your bottom line returns.
Reason 6: The franchise will be easier to finance than an independent business
The Small Business Association has loan guarantee programs available to all small businesses and has even developed loan programs specifically designed for veterans and other targeted groups like women and minorities. However, these are not loans provided directly by the SBA, but through local banks and other lending sources. Each lender has their own criteria for lending, mandates their own capital requirements, and whether you are a franchisee or starting your own independent business, banks today will generally want to see your business plan to show that you can service your debt.
Based on the experience of the franchisor and with their support, franchisees can develop professional business plans for leasing companies and other lenders. Banks also have the added ability in a franchise to review a franchisor’s Financial Performance Representation (Item 19 of the franchisor’s Franchise Disclosure Document) to determine the reasonableness of the projections you are providing to them. Don’t think you will outperform the rest of the franchisor’s system, and understand that the FPR may be skewed to more mature franchisees, whereas you are just starting out. As part of their review lenders will also have the ability to review other material parts of the franchisor’s FDD to get an understanding of the stability of the system and the turnover of the franchise system. Franchising can be a major benefit to securing the loan capital you will need.
The SBA has also established a Franchise Registry that allows franchisors to register their FDD and avoid the need for each regional office of the SBA to determine if the franchisor’s offering meets their standards. In meeting the SBA requirements for registration, franchisors often will modify their Franchise Agreements to lessen the controls they normally require from other franchisees. You should inquire what changes the franchisor is making to your agreement to meet those requirements.
Great franchisors are focused on ensuring that their franchise system is sustainable. One of the major reasons for small business failure is too much debt and the inability of the business owner to service that debt. If the franchisor is more interesting in selling franchises than ensuring your business will be viable, they will show little or no interest on the amount of debt you will obtain. Great franchisors will review your business plan and cash flow and assist you in determining how much debt you can really afford. Most mature well-managed systems can make that prediction for you even before you sign the Franchise Agreement.
When developing your business plan, it is essential that you are realistic in your projection of sales and costs. If you are undercapitalized or overleveraged your chance of failure will be high, and that is not a benefit for either you or the franchisor.
Reason 7: The franchisor is going to be your bank
Rarely. While franchisors may have preferred lender programs with financial institutions that can be of significant benefit to franchisees, most franchisors do not generally provide any direct lending or financing programs for their franchisees. Having loans outstanding from franchisees can create issues for a franchisor should they want to default a franchisee, as the amount of debt you owe them would need to be factored into that equation.
Many franchisors will be part of the International Franchise Association’s (IFA) VetFran or DiversityFran program that offers various discounts on franchise or other fees. Some VetFran or DiversityFran members may also have discount programs on equipment or provide other additional and beneficial services. While I am a supporter of VetFran and at one time chaired that committee for the IFA, it is important for you to understand that the IFA is a trade association and membership in the association is open to all franchisors upon presenting their FDD. Being a member of the IFA is important, as its members generally attend seminars and other programs to improve their systems. Some franchisors have also taken classes and have earned their Certified Franchise Executive (CFE). However, while membership in the IFA is a good indication that your franchisor may be investing in improving their performance, membership in either VetFran or DiversityFran is open to all franchisor members of the IFA. The IFA is not certifying that those members have any additional qualifications, and therefore being a VetFran or DiversityFran franchisor should not be considered as an additional indication of the viability or profitability of the franchise opportunity. Always do your own homework before you invest in any franchise opportunity.
On occasion you will find that some franchise systems will provide reduced initial fees, royalties, and equipment to induce franchisees to invest in their franchise. These franchisors are willing to allow their own return on investment to come from the continuing royalties from the franchisees. Where these programs are offered, you will generally find them front and center in a franchisor’s franchisee recruitment materials.
You can determine what direct and indirect financing programs and other benefits are available from the franchisor by reviewing Item 10 of the franchisor’s FDD and in their marketing materials.
Reason 8: The Other Franchisees in the System
While getting information and support from the franchisor is important, the ability to call an experienced franchisee who can answer your question based on their experience in your exact same business and brand can be priceless. Early in your due diligence process, start to gain knowledge of franchisees that can act as your mentors.
You will also be meeting franchisees and building a network of support by attending the franchisor’s convention and other national, regional or local meetings. These are generally important programs, and you should plan on attending them. At these meetings franchisors often introduce new products and services and provide their franchisees with training. Experienced franchisees can provide you with the guidance on how to best introduce those products and services to your customers and maximize the profitability of your location.
Reason 9: The exit value of your business may be higher
Let’s remember that you do not have any claims on your franchisor’s equity except for the value it adds to your business during your term. When you exit the franchised business, either by retiring early or if you are unfortunately terminated by your franchisor, much of the goodwill value of your business is going to be left behind.
However, during the term, and as long as you are able to transfer your business to a new buyer and for a new full term, or a reasonable portion of your existing and renewal terms, the exit value of your business will generally be higher than a seemingly identical independent business. This is of course assuming you are a franchisee of a well-known, well-managed and well-regarded franchise system. The added selling price of a solid franchise opportunity over an identical independent business can be significant and your exit valuation will generally be higher.
Prior to your entering into the Franchise Agreement, understand what transfer rights you have and whether or not the franchisor will be retaining any right of first refusal. In most franchise systems the franchisor will appropriately retain the right to evaluate who you want to transfer the business to, and that can include your children and heirs. Franchisors selected you because of what they believed were your perceived capabilities, and they rightfully should be able to determine if the person you want to transfer the business to, including your children, meet their qualification standards. Understand that the business you are operating is under a license and if restrictions on transfer cause you concern, maybe you are better off starting your own small business and not becoming a franchisee.
Reason 10: Rate of Success
Every franchisor will tell you, either directly or indirectly, that you will have a better chance at being successful if you invest in their franchise opportunity when compared to other franchise opportunities or an independent business you might start on your own.
Years ago, franchisors regularly claimed success rates based on studies conducted by the Department of Commerce, the Small Business Administration, or Dun & Bradstreet. Even the International Franchise Association at one time published these studies on their website and supported these statistics based on studies conducted for or by their Education Foundation. You won’t see these studies quoted any longer and if you do, I would avoid that franchisor. Many of the studies were based on flawed information and more than a decade ago, the IFA sent out a memo to its members asking them not to use these studies any longer.
Defining success or failure in a franchise system is not as easy as you might imagine. One of the definitions used to measure success is the absence of failure. In that definition, failure is generally defined as the franchise permanently closing its doors. Therefore, if the doors do not close because the business was transferred to the franchisor or a new franchisee, and the business location continues to operate under that definition, the business would not be measured as a failure. The problem with measuring success rates is the inability to determining the circumstance of why the transfer was made. If a franchise is transferred to a new owner because the franchisee is retiring after running a very successful business and sold that business at a sizeable profit, or if the franchisee sold the business at a significant loss, both would be considered a transfer. Also, most studies evaluate the turnover rate at existing franchise systems; systems that are no longer offering franchises are generally not included in those studies. Whether the franchisees in those systems are successful or not is not measured, simply because those systems are not generally part of the study.
Truthfully, whether franchising is more or less successful than other methods of conducting business is irrelevant to you. If you are a franchisee of a great franchise system and you are the only franchisee who ever failed in that franchise system, then for you, that franchise system was a failure. Therefore, I don’t generally make any claims as an expert that franchising as an industry is more successful than owning an independent business. After all, there’s nothing wrong with Starbucks, is there? While for most franchise systems I believe investing in a franchise can be more successful than investing in an independent business, I think the argument is irrelevant. You will not be investing in the franchise industry, but only in a particular franchise system.
Therefore, what is important to you is whether the franchisees in the system you choose to invest in are successful. Did they break even in a reasonable period of time; were they profitable enough to service their business debt; was the franchisee able to earn a living and support their family; and did the business earn a reasonable rate of return? This is what should be important to you. With the support of professional advisors, you need to evaluate every franchise that you are interested in and determine how successful that franchise is likely to be for you.
Do you have further questions about franchising?
MSA’s experts can help you determine if investing in franchising is right for you.