Franchises

Introduction

A franchise is a business that agrees to a method of operation as outlined by another company. Methods of operation can be very narrowly defined and controlled or generally defined. Legal definitions of a franchise vary from state to state and can be restrictive in how one operates. A "business opportunity" can operate very similar to a franchise, but their structure does not fit the legal definition of a franchise. The term franchise is used here to refer to any business structure that sells a business concept that has a proven track record and the purchaser is planning to use that concept in his/her business. To simplify this discussion, the term franchise includes business opportunities.

Franchising is a popular business concept. It is a method of marketing a product or service which is used in a variety of industries such as restaurants, motels, real estate, car services, cleaning services and more. Franchising offers the buyer the advantage of the franchisor's experience, assistance and training. The business can be started with greater efficiency, proven products or systems, brand recognition and higher expectation of success. The initial investment of a franchise can range from a few thousand dollars to hundreds of thousands of dollars. In addition, there may be royalty fees that range from zero to 18 percent of sales.

Any franchise or business opportunity offering should be investigated thoroughly before a contract is signed. Danger signs include inflated promises of large returns on a small investment and sales tactics that pressure the buyer to act immediately. If it appears the franchisor primarily makes money from an up-front sales fee with no care about whether the franchise is a success, the buyer should always act with considerable caution.

How does a franchise differ from other businesses?

Franchising is a way of doing business in which the franchisor (the seller) allows the franchisee (the buyer) to use its trademark, trade name and very often its business system, in exchange for a fee (usually a franchise fee and royalties from sales). There are three key issues that a true franchise offering must contain.

Use of the franchisor's trademark and trade name.
Payment of $500 or more during the first six months of operation.
Provision of assistance and training and/or control of the franchisee.

When clients purchase a franchise or business opportunity, they should expect to receive a proven method of operating a business.

Since there are many types of franchise offerings, it is wise for purchasers to understand the term caveat emptor (buyer beware) and thoroughly understand the terms of a franchise agreement to protect their interest. Though many are reputable, some of them depend on emotion and pressure sales rather than reputation and referrals. Some business offerings encourage buyers to sign up before the opportunity is lost. These opportunities are typically presented in a seminar and offer a special price if the buyer signs up very quickly before the "discounted" price of the opportunity expires. After this up-front fee is paid, merchandise to run the business is sold at inflated prices. Long term support is rarely provided. This basic formula is used in many ways with alterations for different types of products or services.

Why buy a franchise instead of starting a business?

The U.S. Department of Commerce reports that less than 5 percent of franchised businesses have been discontinued since 1985. Statistics from the U.S. Small Business Administration document that approximately 35 percent of new business start-ups are discontinued in their first year. After five years, approximately 90 percent of all franchises are still in business, while only 23 percent of independently owned businesses are still in existence.

Why do these statistics favor purchasing a franchise instead of starting a new business? Generally speaking, a franchisor will have perfected the business' operating methods before beginning to sell franchises. Most franchisors then provide extensive training to new franchisees to ensure they know how to operate the business. As a result, the franchisee will have far fewer operating decisions and problems to resolve. The franchisor is also strongly motivated to ensure that franchisees succeed since the franchisees pay royalties to the franchisor based on their sales.

Financing a franchise

Since franchises have a proven track record of operations, they can provide more accurate information for a business plan. The combination of a reliable business plan and proven track record can make it easier to finance a franchise through traditional financing sources. It is important to understand what fees are required in the purchase of a franchise.

The SBA has a franchise registry that streamlines the process to obtain a SBA loan for registered franchises. To obtain a list of registered franchises, go to the Web site: www.FranchiseRegistry.com/Registry.

Most franchises—especially entire business system franchises—require monetary contributions by franchisees consisting of some or all of the following:

An initial franchise or license fee
Training costs (tuition, room and board, and transportation)
On site start-up aid and promotion charges (some or all of which may be included in the initial franchise or license fee or may in whole or in part be separately stated).
Periodic royalties or service fees and an advertising contribution (usually payable monthly or weekly and based on a specified percentage of sales).

Sometimes there is a charge for centralized bookkeeping, accounting and data processing services. There may also be initial payments for premises, equipment, supplies and opening inventory, if acquired from the franchisor. (If acquired from other approved sources, the payment for them is nonetheless part of your initial opening cost.) Get specific details on all cost items: amount, time of payment, financing arrangements.

Terms like "initial cost," "initial fee," "total cost" and "royalties" should be specifically defined and made quite clear to you. The terms "cash required," "initial cash required," "investment," "down payment" and "equity investment" mean different things in different offerings.

"Initial fees" probably do not include any equipment or product inventory down payment. Make certain your investigation is complete and your understanding clear in the following areas:

Initial license fee. Is there one? How much is the total fee? Is it payable in a lump sum or in installments? If in installments, with or without interest? Is it refundable? Is it non-recurring? If the initial license fees are not the same for each franchise concurrently granted, on what factors are the differences based? Does an initial license fee include compensation in full for any or all of the following? Does it include use of the current operation manual, training and start-up aid, including personal on site and promotional assistance, at franchisor's cost? It does not in many cases. The understanding should be clear, the contract explicit.
Continuing regular fees. Are there periodic royalties? How much are they? How are they determined? In business format franchising, generally, there is a periodic royalty (usually payable monthly or weekly) commonly based on a percentage of sales. How and when are sales and royalties reported and royalties paid? Royalties are not only payment for use of a trademark and trade name (and, where available and applicable, other commercial symbols, patents or formulas) but may also constitute a fee for services to be performed by franchisors. If the periodic payment is in part a service fee, what on-going services are you to receive from the franchisor? Are accounting services included or available? Are they computerized? Will updated merchandising services, operating manuals and training be furnished without additional, or at nominal, cost?
Other fees. What other fees and charges, if any, are payable (for example, advertising and promotion)?
Total cost. Do not confuse "initial fees," "initial cash required," "initial investment" or "initial costs" with total costs. Initial cost or initial investment may require computation and inclusion of additional items in addition to initial franchise or license fees and royalties. Inquiry should be made: are you required to purchase or rent business premises? Who finds the site? What is its cost to you as purchaser or lessor? How is it to be financed, if purchased? Does "initial" cost or investment include an "opening" inventory of products and supplies; a down payment on equipment and fixtures; a lease security payment; or all or part of the franchise fee? What amount is attributable to each such item? Don't confuse down payment or initial cost with ultimate cost. What are deferred balances? Who finances any deferred balances? At what interest? If the franchisor doesn't, is help in finding a source of financing offered? Have you received commitment for financing offered? Have you received commitment for financing before committing yourself? May you seek competitive financing sources or is use of the franchisor or its designated source mandatory? (It should not be.) What are construction, remodeling and decorating costs, security deposits and initial equipment and inventory requirements costs? In determining total costs, check every aspect of the deal. Do not overlook the cost of finding, buying or leasing, and improving and equipping a business location, and obtaining zoning licenses for the operation at that location and the financing costs involved. In determining total opening costs do not overlook working capital and rent, inventory, payroll, insurance and your own promotions and salary during the first year. Know what your monthly debt service will be under your deferred payments financing.

What franchises are available?

Publications

There are an estimated 15,000 franchises available in the United States. Publications that list these franchises include:

International Franchise Association's Franchise Opportunities Guide
US Department of Commerce's Franchise Opportunities Handbook
Entrepreneur Magazine's January Issue: Annual Franchise 500

The Internet

How to decide if a franchise is right

Are you willing to follow the franchisor’s operating system to the letter as long as the franchise is owned? Some will want to experiment with the operating methods and seek ways to improve it or adapt it to his/her own style. A franchisee may be contractually obligated to strictly follow the franchisor’s operating manual; others may offer some flexibility in individual franchisee operations.

Will you be proud to sell this product or service? Just as with an independently owned business, owners must be able to enjoy their work since it may require very hard work—perhaps harder than one ever has for any previous employer. Owning a franchise, or any kind of business, requires a major commitment of time and effort.

Do you have some experience in business? Franchisors prefer that owners have some previous experience, and usually require the new owner to undergo training on the franchise way of operating. This training is usually at the expense of the owner and should be understood before the purchase. In some cases, the franchisor will require some work experience in their system before a buyer can qualify to own a franchise.

How to evaluate a franchise

There are three critical things to do when evaluating a franchise offering:

Obtain and read the legal documents provided by the franchisor
Interview current franchisees
Engage an attorney with experience in franchise law

Up until July 1, 2008 the franchisor has been legally obligated to provide a prospective buyer with a Uniform Franchise Offering Circular (UFOC)* and a franchise agreement. (This is required for franchises that fit the legal definition of a franchise and may not apply to business opportunities that fit under this discussion of a franchise). These documents will be provided by the franchisor when the individual is serious about the purchase.

*However, effective July 1, 2008 franchisors must change to the Amended Franchise Rule. Go to www.franchise.org for a downloadable Compliance Guide and FAQ's on the Amended Rule. You may also read the full text at www.ftc.gov.

Franchisors are also required to provide a complete listing of the current franchisees, including their addresses and phone numbers. Current franchisees are likely to offer the best advice to you about purchasing the franchise. You should attempt to contact a cross section of other franchisees. Go visit as many of them as possible and telephone the ones who are too far away to visit. Don't expect any reply to a mail inquiry. Consider the following questions to ask other franchise owners:

How well does the product/service sell? How strong is customer demand?
How strong is the brand identity?
What level of service does the franchisor provide?
How do your customers feel about the prices?
Are there any operating methods do you dislike?
Was the training and assistance adequate?
How is the location of your business? Did the franchisor help with the selection of the location?
How solid is the franchisor's reputation?
What are the franchise fees?
What do you get for each type of fee?
How long did it take you to break even?
Would you buy this franchise again?
Did you negotiate any aspects of the franchise agreement?
What can I expect for my first year sales?
What marketing support does the franchise provide?
How often does the franchisor update the product line? Does the product line stay current with your local market demand?

Consider the following questions to ask the franchisor:

Do a patent, copyright and/or trademark protect the product?
Do you have an exclusive territory? Do I have the first right of refusal for new franchises in my territory?
What is the planned rate of growth for new franchises in my territory?
How many outlets are company-owned?
Have any franchisees failed? Why?
Can the franchise be transferred to another owner? What does this require?

Select an attorney to review the Amended Franchise Rule Offering and the franchise agreement.

Ask your attorney for referrals to accountants who specialize in franchises, then select one to review the franchisor's audited financial condition. If the franchisor goes out of business, what would happen to your business?

Using franchising as a method to expand a business

Franchising your existing business operation is a way to expand your business. Some advantages to this include:

Less capital is required to grow because the capital requirements are shifted to the franchisee.
Franchisees are motivated business owners with a financial stake in the organization.
Franchise networks can achieve economies of scale through joint procurement.

Some disadvantages of using franchising to grow include:

Developing the agreements to adequately protect your interests as well as provide sufficient control over the operations of the franchisee. This requires an increase in legal fees to properly accomplish.
More administrative time will be required to properly manage franchisee training and operational support.
Increased legal restrictions with which to comply and understand.

Where can I get more information about franchising?

The International Franchise Association (IFA) is a professional organization dedicated to ethical business dealings among franchisers and franchisees. Members agree to abide by a comprehensive code of ethics.

International Franchise Association
1350 New York Ave., N.W., Suite 900
Washington, D.C. 20005-4709
(202) 628-8000
www.franchise.org

Expo Shows and Events:
IFA sponsors a Convention as well as Expos and Shows throughout the United States and in several foreign countries. Go to the IFA site, www.franchise.org for details.

Magazines such as Entrepreneur, Success and INC often have articles on franchising and will contain advertisements by franchisers. Each January, Entrepreneur Magazine features its annual Franchise 500, a listing of their top-rated franchises. This issue should be retained throughout the year to assist you in helping clients locate and evaluate franchises.

The Franchise Opportunities Handbook is published by the U.S. Department of Commerce and is available in public libraries. It can also be ordered at a nominal cost from the Government Printing Office.

Why use a franchise law attorney?

Self-protection:
The franchisor has an attorney to protect the company's interests. Therefore, you need your own attorney to protect your interests. It is critical that the attorney inform you of all of the crucial issues before signing a contract that will be binding for 5, 10, 15, or even 20 years. An attorney who specializes in franchise law will have a clear understanding of both federal and state regulations.

Federal Regulation:
Franchisors must comply with Federal Trade Commission rules. Effective July 1, 2008 the franchisor must comply with the Franchise Amended Rule. Go to www.franchise.org to download a copy of the Compliance Guide and FAQ's.

State Regulation:
States' laws governing franchises differ. Contact the appropriate state office for information on regulations for franchises. In most states that would be the Secretary of State.

Franchise tax

Check each state in which you plan to operate for requirements to pay income tax. In Missouri, resources are available via the Taxes section of the Resource Library and the Missouri Department of Revenue whose web site contains downloadable forms and related information at dor.mo.gov.

Key Contact

Tax Assistance Center - Jefferson City, MO
3237 West Truman Boulevard, Suite 100
Business Taxes: 573-751-7191

- Authored by: Missouri Small Business and Technology Development Centers; Source: MO SBDC Professional Development Manual; Updated 6/2/08 by Jane Cargill, MO SBTDC