So you are thinking about
buying a franchise
. Congratulations. You are about to embark on one of the most
exciting and potentially rewarding experiences of your life.
And, if you are like most
franchise
buyers, this will likely be one of the scariest things you
will ever do.
And, after all, this fear is only natural. If you are a first
time
franchise
buyer, you have no idea of what to expect out of the
franchise buying process. At the same time, you know that if
you go through with it, you may need to quit your job, walk
away from your secure benefits package, and trust a group of
people you have never met with a large portion of your life's
savings to start a business you don't know.
And the
franchise
universe does not make it simple for you. There are over
3,000
different companies offering franchises in the United
States
. Every single one of them will have a franchise salesperson
who will be motivated to tell you why their franchise - and
only their franchise - will meet your long-term personal
needs. And while there may be a number of franchises that
would be a good fit, the risk of making a mistake can be
catastrophic.
So how does one manage to make the right choice with
everything on the line?
Start Your Journey at Home
To paraphrase the wisdom of Cheshire Cat in Alice in
Wonderland, "If you don't know where you're going, then any
road will take you there."
Never were truer words spoken in a
franchise
context.
But in choosing the right franchise for you, the first thing
you need to understand is your starting point.
There are literally thousands of great
franchise opportunities
being marketed today. But only a handful will be a good fit
for you. So before
buying a franchise
, be sure you understand yourself.
Perhaps the single most important question you can address is
whether you are too "
entrepreneurial
" for franchising. As a franchisee, you will need to follow
the rules established by your franchisor. And while most
franchisors will provide their franchisees with an
opportunity to provide them with input, ultimately, it is the
franchisor who decides what is best for the system. If you
want to introduce a new product or service, you will need to
go to the franchisor to get permission. So ask yourself if
you are comfortable in following the rules - because if you
aren't perhaps
franchising
is not right for you.
As part of your introspection, you also need to candidly
assess your personal strengths and
weaknesses
. Remember, any business system is only as good as the people
who execute it. And if you do not have the requisite skills,
you may find yourself failing where others have succeeded.
Are you good at sales? Are you good at managing and
motivating people? Different
franchises
will require different skill sets, and you will want to look
at those businesses that will help you to best capitalize on
yours. In
assessing your strengths and weaknesses
, be sure to be as objective as possible. Far more
franchisees have found themselves harmed from overestimating
their strengths than those who have overestimated their
shortcomings.
Likewise, remember that the
purchase of a franchise
is not something that is easily unwound. Chances are that
once you
buy the franchise
you will not be able to recapture your initial investment
(and you may not be able to resell it at all) until you are
making a profit. In all likelihood, the franchise you
purchase will require your hands-on involvement for years -
and maybe decades. So another important piece of the
self-assessment
puzzle will be whether you like the "job" you will be doing.
What role would ignite your passions and make you happy to
come to work every day? Will the business itself suit your
lifestyle?
Finally, be sure to understand your risk tolerance. Some
people are more comfortable with risk than are others. How
much risk can you take and still sleep at night? Take your
personal circumstances into account when making this
decision. Are you close to retirement? Do you have a family
to provide for? Does your spouse provide you with a second
income? Ultimately, you need to understand whether you are
willing to "bet the farm" or whether you need to limit your
risk exposure.
Knowing your risk tolerance will put you in a position to
quantify the personal and financial resources you are willing
to put at risk. Ultimately, you need to understand how much
capital you are willing to invest and how you will obtain it.
How Full Is Your Tank?
Before you start your journey, it is important to be sure you
know how much fuel you have, lest you run out of gas before
you get there. And a vital part of that process involves
understanding how financing works in this new economy. Gone
are the days of 90%
financing
on a signature. In most instances today, you will need to
have at least 30% of the franchise investment in cash and
even then will only obtain financing if your credit score,
personal balance sheet, and other contributing factors
(spousal income, relevant experience, living expenses, etc.)
measure up.
While some franchisors have
finance programs
for their franchisees, many do not. So if the assets you will
be purchasing as a part of your franchise do not have a ready
resale value, your banker will want to know that you have
personal assets that they can sell should your business fail.
Generally, those assets will come in the form of real estate,
stocks, or retirement accounts - all of which can be
leveraged to allow you a broader assortment of franchise
choices. And while the size of the investment will not
dictate the amount of the return, smaller investments will
tend to be service-oriented franchises which may or may not
suit your personal skill set.
In today's market, you can probably expect a loan-to-value
ratio in the area of 75% or better. In other words, if you
wanted to borrow $75,000 from a bank, you would need to
secure that loan with $100,000 in assets - over and above the
cash portion of the investment. And those assets will be
valued based on what the bank thinks they are worth - not
based on what you think they are worth. So if you have
$35,000 in cash, a strong credit rating, and a net worth
(your total assets less your total liabilities) of $100,000,
you could borrow $75,000 - allowing you to afford a total
investment of $110,000. (And bear in mind, that your total
amount of risk is equal to the $110,000 - not just the cash
you invest - so invest only what you are willing to put at
risk.)
With this understanding of what you can afford along with
your knowledge of the type of business in which you might
excel, you can start your search in earnest. Sites like
www.franchiseexpo.com
provide you with an ability to search franchises based on the
three most relevant factors:
industry
,
investment required
, and
available territories
. So you can
start
your search
there.
Chances are, of course, that you will find far more
opportunities that are appealing than you can reasonably
investigate. So at this point, you may need to do some
pruning. One of the first screens that you might apply could
be the size of the franchisor. And how you screen will be a
personal choice. Larger franchisors will likely be stronger
financially, will be able to provide more support, and will
have a longer track record with which to judge performance.
Smaller franchisors will likely provide you with one-on-one
interaction with the founder and other senior executives
along with the opportunity to get in on the ground floor of a
hot new concept.
At this stage of your analysis, the more information you can
obtain the better. So ask the franchisors who are on your
list for information on their concept. Most will have
promotional materials that they can send you and virtually
all will have websites where you can do additional research.
Don't just stop at their website, of course. Google the
company and read everything you can on both the company and
the industry to make sure you are as well-informed as
possible.
Bear in mind that one element of risk that will be different
for every franchisee involves competitors - so be sure to
research your franchisor's competitors (both local and
national) before getting too serious. Even the best concept
can fail if it is introduced in the wrong market. So if your
franchisor cannot show you how you will beat them in the
consumer market, tread with care.
Reading the Map
As you narrow your list, the chances are that you will have
one or more franchise salespeople who will be calling you to
try to help you through the
franchise buying process
. Often, these salespeople will have their own "process" that
they will like to take you through as you go through your
investigation. But ultimately, you will want to start looking
at some hard data.
The roadmap for your journey will be the
Franchise Disclosure Document
(often referred to as the
FDD
). Under FTC Rule 436, every franchisor is required to
provide this document to prospective franchisees 14 calendar
days prior to signing the franchise agreement or accepting
any payments. This document will contain a tremendous amount
of information - in a standard, prescribed format - that will
allow you to better understand the franchise investment you
are considering. Under FTC Rule 436, a franchisor must
provide this document to buyers on reasonable request, so
once you are serious about a particular franchise you should
ask the franchisor to provide this document.
The
FDD
itself contains 22 separate items (plus a receipt page) that
will provide you with information on the franchisor (Items 1,
2, 3, 4, 13, 14, 18, 20, and 21), information on the costs of
the franchise (Items 5, 6, 7), information on the contractual
relationship you are considering (Items 8, 9, 10, 11, 12, 15,
16, 17, and 22) and information on what you may be able to
earn (Item 19).
In reading the
FDD
, remember that the information it contains is written by the
franchisor (and not vetted by any agency), and as such, it
may or may not be reliable. So read it with a grain of salt.
While you will be tempted to start with the question: "How
much money can I make?" perhaps the most important question
on which to focus is "How likely is it that I will fail?"
There are a number of "qualitative" factors that you can look
at in making this assessment. How long has the franchisor
been in business? How many locations has the franchisor
opened? How much experience does the management team bring to
the table?
Look at the franchisor's history of litigation for both the
number and the types of lawsuits reported. The best
franchisors often report no litigation, although the bigger
the system, the more likely that there will be some disputes.
Determine if any of the reported litigation poses a
significant threat to the system. A trademark action could
force the system to change its brand. Or a major vicarious
liability suit could bankrupt the franchisor. And, of course,
lawsuits that are a result of franchisee dissatisfaction
should raise a red flag.
Another measure of risk is the financial performance of the
franchisor. Ideally, your target franchisor will be
profitable and will boast a strong Balance Sheet. But if you
are looking at a newer franchisor, understand that many
companies will establish new entities to franchise (and their
company-owned operations are often found in a separate
entity). So dig into the numbers.
Another measure of risk can be found in franchisee turnover,
which can be calculated based on Item 20 of the
FDD
. Turnover is calculated by dividing the number of
franchisees who have left the system by the total number of
franchisees in the system. Generally speaking, the higher the
turnover ratio, the greater the risk. But again, all may not
be as it seems. While some turnover may be a reflection of
failed franchisees, turnover could also reflect happy
franchisees selling their locations at a profit. So it is
important to look at the numbers closely enough to understand
what is happening. And, in the process, bear in mind a
younger franchisor may have a lower turnover rate simply
because failing franchisees have not had time to capitulate.
The Destination - Financial Returns
Of course, everyone wants a low-risk franchise that promises
high returns. But the reality is that there is no such
animal. And estimating your potential returns is not always
so easy.
Perhaps the easiest way to estimate returns is to look at
Item 19 of the
FDD
. But unfortunately, only about 30% of U.S. franchisors
choose to disclose anything about potential earnings in their
system. Since these disclosures are voluntary, there can be
any number of reasons why franchisors would avoid making
them. Some might feel that providing these disclosures might
provide their prospects with inaccurate information. Others
may choose not to disclose because they do not want to
provide competitors with information on their business
economics. Others may do so because they fear (often wrongly)
that this will increase their exposure to litigation. And
others may choose not to make a disclosure because their
earnings just are not as good as those reported by their
competitors.
If a franchisor decides not to disclose anything in their
Item 19, you will need to do more digging. And, in fact, even
if the franchisor chooses to disclose elements of their
financial performance, you should still do this additional
digging. Don't take anything for granted.
Start by calling franchisees
. Unless you are looking at a brand-new franchisor, you
should talk to as many franchisees as is feasible -- and do
not limit yourself to franchisees who are "recommended" by
the franchisor.
When speaking to these franchisees, some may be embarrassed
at their lack of earnings or may prefer not to disclose this
information. Some may be sheltering their income to avoid
taxes. So to avoid potential confusion, ask very specific
questions. What were your gross revenues? What are your cost
of goods sold? Your labor costs? Can you describe your
location? How much is your rent? How much inventory do you
maintain? What is your inventory turnover? How much money did
you invest when you opened? How long did it take you to
break-even?
In short, ask questions that will allow you to create your
own financial analysis rather than looking for an easy
answer. While asking "how much money did you make?" might be
the easy question, it may also be misleading.
As a part of this process, be sure that you also ask about
the support provided by the franchisor, the openness and
frequency of communication, and, of course, whether the
franchisee would buy the same franchise if they had to do it
over again? Ask about trends in the marketplace, competitors,
and how they see the market evolving in the next five years.
Develop a script so that you can be sure to cover everything.
And don't limit your interviews to franchisees. Talk to
anyone who may help you assess the opportunity. Your banker,
suppliers, and even competitors. If there is a site involved,
speak to your local landlords do determine what locations are
available and at what cost.
Once you have developed your
financial analysis
, you will need to measure your return in a consistent
manner. In order to do this, it is important that you do not
focus on your projected income. Instead, measure business
potential based on Return on Investment - as this will level
the playing field between franchises at different
investment levels
.
In order to do this, you will need to estimate your start-up
costs - which are found in Item 7 of the
FDD
. But since franchisors will use different assumptions in
estimating these costs in their
FDD
s, you cannot simply rely on an "average" of the costs found
in the
FDD
. Again, this is where the homework you have done will pay
dividends. When in doubt, estimate on the high side. No one
ever went out of business because they didn't spend all their
money.
In looking for your numerator (your return), take the
projected income from your year two or year three financial
projections (as year one is really your start-up year). Your
pro forma income statement should account for a reasonable
salary for the unit manager (you, if you will fill that role)
which will not be included in the return (as this is a return
on your time, not a return on your investment). And since you
will be using total investment as a denominator, your
numerator should not reflect debt service, depreciation or
taxes.
Then divide your projected earnings by your start-up costs to
figure your ROI.
Ultimately, franchises that have higher estimated risks
should be able to offer you a higher return than a low risk
franchise to offset the incremental risk.
Always Ask For Directions
The purchase of a franchise is often the single largest
financial decisions you will ever make. Not only will you be
investing a great deal of your life's savings, but you will
be investing your time and earning power into this business -
perhaps for decades. And, since this decision will involve
you so intimately, it is also one of the most emotional
decisions you will make - and as emotions dictate, we tend to
be blind to the downside when we fall in love.
So perhaps the single most important thing you can do is hire
experts who will provide you with an objective third-party
opinion. Hire an accountant to look over your
financial analysis
(or have one create your financial analysis if this is not
your strong suit). Ask the accountant to review both your
business plan and the franchisor's financial health. And
whatever you do, retain an
attorney
who specialize in franchising (not your inexpensive
brother-in-law) before you sign on the dotted line. The money
you invest with experts is often the best investment you will
ever make.
Remember; when you make the ultimate decision, there are a
number of questions you should be asking. Are you passionate
about the business? Would you excel at it? Does it suit your
lifestyle? But in the end, the ultimate decision on whether
you should make any investment will boil to risk versus
return. If you carefully plan your journey and ask directions
from those that have been there, you will have a far better
chance of finding your way without encountering any problems
along the road.
* * *
Mark Siebert
is the CEO of the iFranchise Group, a management consulting
firm specializing in providing consulting services to
start-up and established franchisors. The iFranchise Group's
consultants have over 500 years of franchise experience and
have worked with 98 of the nation's top 200 franchisors. |