Before You Buy a Franchise | Franchise Information for the Uninitiated
State Bar Certified Specialist, Franchise & Distribution Law
by Tal Grinblat
818.907.3284
When you buy a franchise, you buy more than just the right to sell certain services and/or products. You buy name recognition, a marketing plan and the expertise of business professionals who hopefully have track records for competing in the marketplace.
There’s a certain amount of security in buying a franchise that has name recognition you don’t necessarily get when launching a brand new business concept – and that level of comfort can be especially attractive to new business owners.
However, buying a franchise can also involve significant financial costs and risks, so it’s important to do a thorough investigation before buying and signing any franchise agreement.
Here are some things to consider:
1. Franchise Costs
You’ll want to consider the total cost of getting into the franchise, which involves more than the initial franchise fee. Before pulling the trigger, a prospect needs to consider all the following fees and costs of buying a franchise, such as:
▪ Franchise Fee – Depending on the franchise system involved, this fee could be several thousand to hundreds of thousands of dollars.
▪ Real Estate – You will need to consider whether to buy or lease the site where your franchise will operate. Some franchisors will have strict specifications regarding the location of your new business.
▪ Build Out Costs, including Equipment — Not all franchises are equal in terms of build out costs.
Some systems require a relatively small initial outlay for build out costs (costs for building and equipping the franchise), if the franchise is a cart in a mall or a department within another store, for example.
Other systems can have significant costs which you will need to incur for constructing the premises following the franchisor’s criteria and equipping the franchise.
In addition, some systems require the purchase of proprietary systems, equipment and software, not readily available elsewhere which can increase the start up costs, sometimes fairly dramatically. Others do not. So it’s important to compare these differences among competitors.
▪ Royalty Payments – You’ll need to pay royalty fees for the use of the franchisor’s name and system. These payments may be a flat monthly fee or based on gross revenue by week or by month. These fees can range from three percent or more than ten percent off the top. You’ll need to study the franchise program to assess whether you can make a decent profit after royalties are deducted.
▪ Advertising Fee Contributions – Many franchise systems require franchisees to contribute to a national or regional advertising fund (in addition to local advertising requirements). These fees are used to promote the franchise system as a whole. This type of advertising can build brand recognition system-wide.
However, franchisors usually have wide discretion to decide the type of advertising to be used (Internet, broadcast, billboard) and how to direct the advertising—whether to focus on areas where there is a greater concentration of franchisees, etc. So these expenditures may not benefit all franchisees proportionately and franchisees generally have very little say on how the franchise system spends this money.
2. Franchise Choices
In conducting your due diligence, how do you find out which franchise is right for you? First, you should decide on a particular industry based on the type of work you like to do. Then determine how much time you are willing to commit to that work. Do you want a franchise with a set, 9-5 schedule? Are you interested in food service, graphic design, or auto repair?
There are many ways to choose the right franchise for you. Three methods for doing so are:
▪ Getting Recommendations from Existing Franchisees – One of the best resources to determine whether a concept is a good franchise opportunity includes speaking to existing franchisees. An existing franchisee can provide information about the franchisor’s principals (are they easy to deal with), whether the franchisee recommends the franchise system and the potential sales and revenue a franchisee can expect to derive.
▪ Attending Franchise Expositions – There are various franchise trade shows, such as The West Coast Franchise Expo in Los Angeles. These are great forums for discovering the wide variety of franchise opportunities available.
▪ Consulting Franchise Brokers – A broker can match your interests, resources and needs to available franchise opportunities. However, most brokers work on commission and may try to match you to the franchises that require larger franchise fees.
Other brokers may work with a limited number of franchisors, so they may offer you fewer choices than brokers that have a wider network of referral opportunities. It is therefore important to conduct due diligence on any broker you speak to.
3. Franchise Disclosure Documents
The Federal Trade Commission requires a franchisor to provide you with a disclosure document (usually referred to as an FDD) at least 14 days before you sign a franchise agreement or pay any money to the franchisor.
▪ Business Background – of the franchise company and its officers, directors and managers, special laws that affect the franchise, required permits to operate the franchise and general description of the competition.
▪ Litigation History – material litigation, administrative cases, government orders and injunctions affecting the franchisor and its principals in the last 10 years.
▪ Bankruptcy – recent bankruptcies filed by the franchisor and its principals in the last 10 years.
▪ Franchise Costs and Initial Investment – initial and ongoing royalties, advertising fees, and all other payments the franchisee must make both to enter the franchise and during the franchise relationship. The franchisor will also provide information on the expected initial investment to enter the franchise.
▪ Training – provided by the franchisor before start of the franchise.
▪ Exclusivity – provided by the franchisor from other franchisor owned and franchised outlets.
▪ Information – on the number of franchised and company owned outlets, terminations, non-renewals, etc. – the FDD will provide information on current and former franchisees, number of franchisee terminations, cancellations and non-renewals in the last three years and other useful information to find out whether the franchise system is stable or rife with turnover.
▪ Restrictions imposed on franchisees – in terms of supplies, services, sales, products offered, etc.
▪ Renewal, Transfer Obligations and Post Termination Obligations – Conditions imposed by the franchisor for renewing the franchise, selling or assigning the franchise to another; and any post termination obligations, including the existence of any non-compete requirements.
▪ Audited Financial Statements – the FDD will include audited financial statements going back 3 years to enable the franchisee to assess how the franchisor is doing financially, whether the franchisor is making or losing money and whether they are financially stable or in decline. The audit report will also indicate whether the auditor believes the franchise company is showing signs of trouble.
Other than the above, there are many sources of information available through the Federal Trade Commission, the California Department of Corporations and other sites. So be sure to do your due diligence before jumping in.
The most important consideration before buying a franchise though, is protecting yourself financially. Be sure to have your accountant and franchise attorney look over the franchise documents, including the terms of the agreements, financial statements and the franchisor’s business structure, before you sign any agreements to ensure it’s the right fit for you.
Tal Grinblat is a Certified Specialist in Franchise and Distribution Law, as specified by the State Bar of California. For more information, call Mr. Grinblat at 818.990.2120.