Franchising 101: What to Know Before You Invest

It seems like a lifetime ago, but I once worked for Starbucks. The pay wasn’t great, but the perks were good. Just saving you the trouble of making that joke yourself. One of the most asked questions I heard was, “How can I get one of these franchises?” And the answer was, “Starbucks doesn’t franchise. Every store is corporately owned, and the ones in grocery stores are managed through affiliate relationships with those corporations.”

But for most companies, that’s a hard way to grow a business, it’s much more efficient to have a couple of successful locations and then franchise the brand. And for most entrepreneurs, a franchise is a great way to get started in business ownership. It’s been said that you don’t buy a franchise to get rich, you do it to get experience of running a business.
Wait a second … not get rich?
That’s right, most franchisees don’t get rich by owning a single store — they have to own multiple locations before the money starts arriving in any kind of meaningful amounts. And depending on the franchisor, there’s an easy way for franchisees to have a million dollars in the bank after 12 months in business. You do it by starting with three million dollars in the bank.
Franchisee or franchisor? If you’re buying a franchise license, you’re a Zee, if you’re the organization that owns the brand you’re the Zor.
Avoiding the pitfalls of franchising is as important as seizing the benefits — and for both of these, it’s often easier to have someone point them out so you can figure out what action to take.

Royalties

Before you invest a dime in a franchise, know what the royalty structure is.
You probably have an idea of how music royalties work — artists get paid when their song is used. The same is true of franchises — the franchisor gets paid when their brand is used by a franchisee. Which is all the time. So as a franshisee you can expect to pay 6-10 percent of your revenue as royalties to your franchisor. It’s normal, and not a big deal. The money is used to maintain the systems you have access to as a franchisee, training materials, uniforms, advertizing — all the things that promote the brand (and your franchise in the process).
It’s not a mafia-style tribute to a “boss,” it’s an investment in your franchise brand, and probably worth a lot more than you actually pay.

Franchise or Pyramid?

Check into how the franchisor makes money, is it from creating more franchises or from revenue from existing franchises? As a franchisee, you want to see that the franchise makes its money by selling a product or service. A company that makes money by charging a sign-up fee to franchisees who sign up to sign more people up is unsustainable. At some point, somebody has to do the selling part to generate money. If you can’t see how the revenue is generated by charging people outside the company to buy a product or service, you might be signing up for a pyramid scheme or a multi-level marketing program. Getting some money for promoting and expanding the brand is good — if it’s the only place you can see the money rolling in from, that’s very bad.

Disclosure Document

In the past this document was called the Uniform Franchise Offering Circular (UFOC), but now it’s the Franchise Disclosure Document (FDD). The franchisor was previously required to provide the franchisee with the UFOC at their first meeting, but the FDD only needs to be provided to the franchisee a minimum of 14 days before they sign a contract. The FDD is the place where the franchisor must disclose any previous bankruptcies, and whether any officer of the company has any interest in any of the franchise’s approved suppliers. It should also let the potential franchisee know that they’ll be able to talk to previous franchisees (or not). If the franchisor uses the Internet, catalogs, brochures, telemarketers, or any affiliate marketing programs, these must also be disclosed here.
What is not required in that document is information about how much franchisees can earn. The franchisor doesn’t even have to show you detailed financials. Make sure you understand how the franchisor came to the numbers it discloses (if it discloses any) — make sure that they’re relevant to your market area, or that they reflect net revenues.

Communication

How, and how often, you and your franchisor communicate is essential to building a good relationship with a person at the franchise organization. A good relationship will be vital in managing any concerns or grievances you have. A franchisor that doesn’t communicate with you may not see you as a real person, only a royalty check, and may be less likely to work with you if you have problems.

Supply chain

Are you expected to buy your materials from a particular supplier? As a small business owner, you have the ability to seek out your own suppliers. As a franchisee, you must use suppliers authorized by your franchisor. As a small business you probably have limited bargaining power with your suppliers, but as a franchisee, your franchisor may have a great deal of bargaining power to keep your costs low. However, that doesn’t necessarily mean that the savings are passed onto you.

Location

Do you have a guarantee of an exclusive territory? Competition is good, too much competition is dangerous. If your franchisor will not guarantee that you will be the only franchisee withing a specific radius, think very carefully about how you’d deal with a competitor opening up at the other end of your block. You might change your prices, or do some different marketing. If you’re a franchisee, and the competitor is a competing licensee from the same franchise, you probably won’t be allowed to cut prices, and you might not be allowed to do any of your own marketing. And that leaves convenience and service as the things that will drive people to your store instead of the new one. This kind of competition affects your earnings, not the franchisor’s — there are the same number of customers, but now they’re split between two stores. In the worst case scenario, a better location opens up near you, it’s much more convenient for your customers, and so instead of sharing your customers equally, you lose 70 percent of your revenue — what do you do now?

Contracts

Have a lawyer check over your contract. There might be a thing called an Arbitration Clause. It will state, in a roundabout way, that in the event of a disagreement both the franchisee and the franchisor agree to not take their grievance to court, but to use an independent arbitrator, instead.
Sounds civilized and amicable, no? Actually, maybe not. Here’s the thing: the franchisor will get to pick the independent arbitrator, and they are the party responsible for paying the arbitrator. So, independent or not, how likely is it that your arbitrator will be unbiased, knowing that their next paycheck might depend on the decision they make about your grievance? I’m not saying arbitrators are dishonest, but there is a remarkable amount of anecdotal evidence online which supports the fact that arbitrators are human.
If you think that you won’t ever have a grievance with your franchisor, re-read the points above.
Above all, don’t invest in a franchise until you’ve done an exhaustive amount of homework. Sure it might cost a couple of thousand dollars to figure out you don’t want to open up your very own “Zigi’s Struedel Haus,” but at least you won’t have invested $100,000 or more in a business that fails inside a year.

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