Buying a franchise can be an exciting opportunity to run your own business while benefiting from an established brand and support system. However, like any investment, it comes with risks and challenges. The Federal Trade Commission (FTC) has put together a guide to help you understand what’s involved in buying a franchise, how to evaluate opportunities, and what to look out for before you commit. Here’s an expanded and simplified version of that guide to help you make an informed decision.
What Is a Franchise?
A franchise allows you, the franchisee, to operate a business using the brand name, systems, and support of a larger company, known as the franchisor. In exchange, you pay a franchise fee and often ongoing royalties. This fee gives you the right to use the franchisor’s name for a certain number of years, along with assistance in areas like finding a location, training, marketing, and operations.
The franchisor may support you through newsletters, websites, workshops, or seminars. But keep in mind that owning a franchise also means adhering to specific rules, costs, and controls set by the franchisor.
Costs of Owning a Franchise
1. Initial Franchise Fee and Start-Up Costs:
The initial franchise fee can range from tens of thousands to several hundred thousand dollars. This fee is usually non-refundable. Additionally, you’ll need to cover costs for renting, building, and equipping your outlet, as well as buying inventory. You may also need to pay for licenses, insurance, and promotional activities for your grand opening.
2. Ongoing Royalty Payments:
Many franchises require you to pay royalties, which are typically a percentage of your gross income. These payments continue for the duration of the franchise agreement, even if your business is not profitable. Some contracts require royalty payments even if the franchisor fails to provide promised services or if you terminate the agreement early.
3. Advertising Fees:
You may also need to contribute to an advertising fund. Some of these funds might be used for national advertising campaigns or to attract new franchise owners, rather than promoting your specific outlet.
Franchisor Controls
Franchisors often have strict controls to maintain uniformity across all franchise locations. These controls can limit your ability to make independent business decisions. Here are some areas where franchisors may exert control:
1. Site Approval:
Franchisors may retain the right to approve the location of your outlet. Some conduct extensive studies to ensure the site has good potential for attracting customers.
2. Design and Appearance Standards:
To ensure a consistent brand image, franchisors may impose design and appearance standards. This could include requirements for renovations or design changes over time, which can increase your costs.
3. Restrictions on Goods and Services:
Franchisors may limit what products or services you can offer. For example, a restaurant franchise might not allow you to modify the menu, or an auto repair franchise might restrict you to certain types of repairs.
4. Method of Operation:
Franchisors may dictate specific operational details, such as business hours, employee uniforms, and approved suppliers. You might also be required to sell certain items at discounted prices, affecting your profitability.
5. Sales Territory:
Some franchisors limit your sales area, granting you an “exclusive” territory. However, this may not protect you from all competition. For instance, the franchisor might sell the same products through other channels, like online stores or different franchise models.
Contractual Obligations
Franchise agreements are typically for a set number of years, and you can lose the franchise if you don’t comply with the contract. Here are some key points to consider:
1. Terminations:
A franchisor can terminate your agreement for various reasons, such as failing to pay royalties or not meeting performance standards. Some contracts allow you to correct minor issues, but repeated failures could result in termination and loss of your investment.
2. Renewals:
Franchise agreements are not automatically renewed. At the end of the term, the franchisor may offer a renewal, but the terms might change. These changes could include higher royalty fees, new design standards, or reduced sales territories.
Is a Franchise Right for You?
Before you invest in a franchise, take a hard look at your financial situation, abilities, and goals. Ask yourself:
- How much money do you have to invest? Can you afford to lose this money if things don’t work out?
- Do you need financing, and where will you get it?
- Do you have the necessary skills or experience to run this type of business?
- Are you prepared to follow the franchisor’s rules and guidelines?
- Do you want this to be your main source of income, or is it a side venture?
- Are you in it for the long haul, possibly looking to open multiple outlets?
Finding the Right Franchise Opportunity
There are several ways to research franchise opportunities:
1. Visit Local Outlets:
Talk to current franchise owners in your area about their experiences with the franchisor.
2. Franchise Handbooks:
These resources list available franchises and provide basic information about each. They can be found in libraries or online.
3. Franchise Expositions:
These events allow you to compare different franchise opportunities in one place. Be sure to do some research before attending to narrow down your options.
4. Franchise Brokers:
Brokers can help match you with franchises that fit your budget and interests. However, be aware that brokers often work for franchisors and earn commissions, so their advice might not always be impartial.
Evaluating a Franchise
When considering a franchise, think about the demand for the product or service, the competition, and the support you’ll receive. Here are some important factors to consider:
1. Demand:
Is there a demand for the franchisor’s products or services in your community? Is it a seasonal business, or is it relevant year-round? Be wary of investing in a business that might be a passing trend.
2. Competition:
What’s the level of competition in your area? How many other businesses offer similar products or services? If the market is saturated, it may be difficult to establish your franchise.
3. Your Ability to Operate the Business:
What happens if the franchisor fails or decides to close the business? Will you be able to operate independently if necessary?
4. Name Recognition:
How well-known is the franchisor’s name and brand? A strong brand can help attract customers, but you’ll still need to work on building a loyal customer base in your area.
5. Complaints and Legal Issues:
Check if there have been any complaints or legal actions against the franchisor. This can give you insight into potential problems with the franchise system.
The Franchise Disclosure Document (FDD)
Before investing, you must receive the Franchise Disclosure Document (FDD) at least 14 days before signing any contract or paying any money. The FDD is a critical document that provides detailed information about the franchisor, the franchise system, and the terms of the agreement. Some key sections to pay attention to include:
1. Franchisor’s Background:
This section tells you how long the franchisor has been in business and its competition. It also informs you of any special licenses or permits required.
2. Business Background:
Here, you’ll find information about the executives of the franchise system and their experience.
3. Litigation History:
This section lists any legal issues the franchisor or its executives have faced, including lawsuits or settlements. Multiple claims against the franchisor could indicate problems within the franchise system.
4. Bankruptcy:
If the franchisor or its executives have been involved in a recent bankruptcy, this section will provide details. It’s essential to consider this information when evaluating the franchisor’s financial stability.
If you’re thinking about investing in a franchise, understanding the Franchise Disclosure Document (FDD) is crucial. This document is a legal requirement and provides detailed information about the franchise. Here’s an expanded guide to help you navigate the FDD and what to watch out for.
Initial and Ongoing Costs (FDD Items 5-7)
Starting a franchise involves various costs, some of which are outlined in Items 5-7 of the FDD. These items detail the initial expenses, such as:
- Franchise Fees and Deposits: These are usually non-refundable and required upfront.
- Initial Inventory: The cost of stocking your business with the necessary products.
- Equipment and Signs: The purchase or rental of essential equipment and signage.
- Lease or Rental Costs: Costs related to the property where your franchise will operate.
Beyond the startup phase, there are ongoing costs like:
- Royalties: Regular payments to the franchisor, usually a percentage of your sales.
- Advertising Fees: Contributions to national or regional advertising funds.
It’s important to also consider other potential costs not mentioned directly in these items, such as:
- Promotional Expenses: Costs associated with grand openings or other marketing initiatives.
- Licensing: Fees for business and operating licenses.
- Supplies: The ongoing expense of products or services.
- Real Estate Improvements: Modifications required to make the location suitable for the business.
- Training: Costs for training new employees.
- Insurance: Coverage for various risks associated with operating the business.
- Compliance Costs: Expenses related to meeting local laws, like zoning, waste disposal, and safety codes.
- Employee Salaries: Payroll expenses.
Starting and stabilizing your franchise can be a lengthy process. It may take months to get your business up and running and over a year to break even. Some franchises never achieve profitability. Be sure to estimate both your business operating expenses for the first year and your personal living expenses for up to two years. Comparing these estimates with what other franchisees have experienced can provide valuable insight. Consulting with an accountant can help you evaluate these costs accurately.
Supplier, Territory, and Customer Restrictions (FDD Items 8 and 12)
Items 8 and 12 of the FDD describe any restrictions placed on you as a franchisee. These can include:
- Approved Suppliers: You may be required to purchase goods from specific suppliers.
- Product and Service Limitations: The franchisor may restrict what you can sell.
- Territory Restrictions: Limitations on where and to whom you can sell.
- Internet Sales: Rules regarding selling online, both within and outside your designated territory.
These restrictions can impact your ability to make independent business decisions. If the franchisor doesn’t protect your territory, you might face competition from other franchisees or even the franchisor’s own outlets.
Franchisor’s Advertising and Training (FDD Item 11)
Advertising and training are key components of a successful franchise, and Item 11 of the FDD covers these areas in detail.
Advertising:
- You might be required to contribute a percentage of your sales to advertising funds at the national, regional, or local level.
- Investigate how these funds are used, including the percentage spent on administration, national campaigns, local advertising, or franchise sales.
- Determine if franchisees have any say in how the advertising dollars are spent and whether all franchisees contribute equally.
- Ask if the franchisor receives rebates from placing ads and who benefits from these rebates.
Training:
- The FDD will outline the training program, including the qualifications of the trainers, the duration of the training, and who bears the cost.
- Find out if there’s ongoing training and support available and at what cost.
- It’s crucial to ensure the training provided meets your needs. Speak with current franchisees to gauge the quality of the training they received.
If you have concerns after reviewing Item 11 and talking to franchisees, ask the franchisor if you can review the training materials. If they refuse, even if you offer to sign a confidentiality agreement, this might be a red flag.
Renewal, Termination, Transfer, and Dispute Resolution (FDD Item 17)
Item 17 is particularly important as it covers the conditions under which you can renew your franchise agreement, as well as what happens if the franchise is terminated or sold. Key points include:
- Renewal Terms: Whether you can renew your franchise and what you need to do to qualify.
- Post-Termination Obligations: Often, there are restrictions that prevent you from operating a similar business in the same area after your franchise ends.
- Selling Your Franchise: The steps you need to take to get the franchisor’s approval for selling your franchise.
- Dispute Resolution: Whether you must use arbitration or if you can go to court if a dispute arises.
Understanding these terms is critical to protect your investment and future business plans.
Financial Performance Representations (FDD Item 19)
Item 19 covers any claims the franchisor makes about potential earnings. While franchisors are not required to make these claims, if they do, they must have a reasonable basis for them, and these claims must be included in Item 19.
When reviewing this section, consider:
- Typical Earnings: Ensure the earnings claims are representative of the typical franchisee experience.
- Average Income: Be cautious of average income figures, as they can be skewed by a few high-performing franchises.
- Gross Sales vs. Net Profits: High gross sales figures don’t necessarily mean high profits. Always consider overhead costs.
- Geographic Relevance: Earnings can vary significantly by location, so ensure any claims are relevant to your area.
- Franchisee Backgrounds: Success can depend heavily on the skills and experience of the franchisee, so consider how your background compares to those who have succeeded in the system.
Always ask for written substantiation of any earnings claims and consider consulting an accountant to help evaluate them.
Franchisee and Franchise System Information (FDD Item 20)
Item 20 provides information about the franchisor’s growth and franchisee turnover. High turnover or a large number of closures could indicate problems within the franchise system.
Current and Former Franchisees:
- Item 20 includes contact information for current and former franchisees. Speaking with these individuals can give you a clearer picture of what to expect.
- Contact both recent and long-term franchisees to understand their experiences with the franchisor, the time it took to break even, and the quality of support they received.
- Former franchisees, although sometimes bound by confidentiality agreements, can provide valuable insights into the challenges they faced.
Franchisee Associations:
- Franchisee associations, whether endorsed by the franchisor or independent, can provide information about the relationship between the franchisor and its franchisees. Ask about system issues, problem resolution, and overall satisfaction.
Financial Statements (FDD Item 21)
Item 21 contains the franchisor’s most recent audited financial statements. These are crucial for assessing the financial health of the franchisor. Look for signs of steady growth and a strong support system for franchisees. Consulting an accountant to review these statements is highly recommended.
Evaluating Potential Earnings
Estimating potential earnings is one of the most challenging aspects of investing in a franchise. While some franchisors provide earnings information, it’s essential to scrutinize this data carefully. Consider whether the earnings claims are typical, how averages are calculated, and if the figures provided are gross sales or net profits.
Always be aware of the geographical relevance of the earnings data, and remember that a franchisee’s success can be influenced by their individual skills and background.
Before You Sign the Franchise Agreement
The FDD may change between the time you receive it and when you sign the franchise agreement. Always ask for the most recent version of the FDD before signing. This updated document might include new information that could affect your decision, such as new lawsuits, changes in management, or updated financial performance data.
Additional Sources of Information
Accountants and Lawyers:
- Both an accountant and a lawyer can provide invaluable advice. An accountant can help you understand the financial aspects of the franchise, while a lawyer can clarify your legal obligations.
Banks and Financial Institutions:
- If you need financing, your bank may provide additional financial information about the franchisor. However, remember that bank approval of a loan doesn’t guarantee the franchise is a good investment.
Better Business Bureau (BBB):
- Checking with the BBB can reveal any complaints against the franchisor, which might indicate potential problems.
Government Resources:
- Some states have specific laws regulating franchises. Check with your state’s Attorney General’s office or consumer affairs department for more information.
Federal Trade Commission (FTC):
- The FTC provides resources for both businesses and consumers to help them understand and comply with franchise laws. Their website offers tools and information to help you make an informed decision.
Conclusion
Investing in a franchise is a significant decision that requires careful consideration and due diligence. Understanding the FDD and seeking advice from professionals can help you avoid potential pitfalls and choose a franchise that aligns with your financial goals and business aspirations. Always take the time to thoroughly research and evaluate your options before making a commitment.
