What do Subway, Dunkin', UPS Stores, Domino's Pizza, Jiffy Lube, McDonald's, Burger King, and RE/MAX all have in common? They are all highly successful businesses and they all franchise their operations. If you have ever considered becoming a franchisee, read on for some insight into the benefits and pitfalls.
Key Takeaways
- Buying a franchise can be easier than starting a new business from scratch.
- However, franchisors (the companies that sell franchises) often charge substantial upfront and ongoing fees.
- Franchisors also maintain a degree of control over the franchisee's business and how it operates.
- Franchisors are required by law to provide certain financial and other information to prospective franchisees.
- Anyone considering buying a franchise should also make a point of interviewing current franchisees about their experiences.
What Is a Franchise?
A franchise is a business model used by an established business to expand its reach. The concept dates to the Middle Ages when a king would grant rights for activities such as running a market or brewing ale.
The sponsoring company, which is referred to as a franchisor in the relationship, licenses its proprietary business knowledge, processes, and trademarks to a franchisee, who can then sell the company's products or services under its name.
The franchisor and the franchisee enter into a franchise agreement, setting down the financial details of the relationship. The franchisor typically gains access to a new geographic market, while also receiving a variety of fees from the franchisee. Those can include:
- An initial sum, known as the franchise fee
- Ongoing royalty fees, which are usually paid monthly based on the franchisee's sales
- Advertising charges
- Licensing fees
- A percentage of the franchisee's gross profit
Potential Benefits for Franchisees
Buying into a franchise can remove much of the guesswork involved in setting up a brand new business.
In some sense, franchising is akin to a business in a box. That's because it comes with a recognized brand name, consistent advertising, branding, and presentation—think uniforms, store colors, signage, and products—as well as a defined set of operational procedures for running the business. Just open the box, take out the components, and you are ready to go.
That doesn't mean that every franchise will be successful. For every well-known, well-established franchise, there may be dozens that come and go, taking their franchisees' investments with them. The franchise economy was hit especially hard by the COVID-19 pandemic. According to a 2021 report from the International Franchise Association, roughly 20,000 franchise locations and 900,000 jobs were lost in 2020.
Even in good times, franchises fail for the same reasons that other businesses do: poor concepts, bad locations, inept management, and so forth. In addition, some franchise offerings are little more than scams, such as pyramid schemes, intended to fleece gullible investors.
Benefits for the Franchisor
As noted above, franchisors get paid for their ideas, expertise, and assistance. The payments typically include a lump-sum franchise fee, a percentage of the franchisee's gross sales, and other costs, such as royalties, advertising, and licensing fees.
For example, Dunkin' charges an initial fee of $40,000 to $90,000 for a traditional franchise,along with 5.9% in royalties, and 5% for advertising. In total, the franchisee's initial investment can range from $526,900 to $1,809,500, the company says.
Using those numbers, a store that does $900,000 in annual sales would owe nearly $100,000 to the company. If you add in about $200,000 for the cost of materials, the franchisee would be left with about $600,000. From this, the franchisee must pay rent, utilities, wages, taxes, and other expenses before realizing any profit.
While buying a franchise can be easier than starting a business from scratch, owners also give up some of the autonomy they would otherwise have had. The franchisor typically controls many of the aspects of the business, such as site approval and maintenance, operational methods, and the territory where the franchisee can sell its products or services.
Getting Started as a Franchisee
Before you invest in your own franchise, plan to do some serious research. Try to talk to at least a half dozen current franchisees—and not just ones that the company may refer you to.In particular find out what kind of time commitment is involved if you intend to play a hands-on role in the business.
Take a long, hard look at the numbers, starting with the franchise disclosure document (FDD) that the franchisor should supply before you commit. Make sure you thoroughly understand the startup costs, ongoing costs, and the amount of money you can reasonably expect to earn.
Find out how far away the next closest franchise location is and where the next new location can be built. You don't want to be in competition with another franchisee right down the block.
Be sure to ask out about any expansion opportunities that may be available to you if your location is a success.
Finally, develop an exit plan in case you can't handle it and decide to call it quits.If you're putting your savings into a franchise, it is probably best not to invest every last cent.
What Is a Franchise Disclosure Document (FDD)?
Under Federal Trade Commission (FTC) rules, franchisors must supply potential franchises with a franchise disclosure document (FDD) at least 14 days before they enter into a contract or exchange any money. It consists of 22 items, with information on the franchisor's business history, including any litigation or bankruptcies; its three most recent audited annual financial statements; the fees and restrictions imposed on franchisees; and much more.
According to the FTC, "Providing the FDD doesn't establish that a franchisor is reputable—it's required by law, after all—but if a franchisor doesn't promptly provide this mandatory document, gives you an incomplete FDD, evades your probing questions, or tries to rush you through the process, it doesn't speak well of their approach to legal compliance."
What Is a Pyramid Scheme?
A pyramid scheme is a type of fraud in which early investors are paid out of money put in by later investors, rather than by any real profits the business may be earning. These schemes rely on the constant recruitment of new investors until the pyramid eventually collapses, leaving later investors empty-handed. Some pyramid schemes represent themselves as franchise business opportunities, such as distributorships.
How Can You Avoid a Franchise Scam?
A franchisor that is on the up and up should provide you with an abundance of financial information and be willing to answer any questions you may have. According to the United States Postal Service, three warning signs that a franchise may be a scam are: "promises of unrealistic profits, promoters who seem more interested in selling their distributorship or franchise than they are in the product or service being offered, [and] promoters who are
reluctant to let you contact current franchisees." The New York State attorney general's office says that high-pressure sales tactics are another tip-off.
The Bottom Line
If you want to run your own business, buying a franchise can be an attractive alternative to starting from scratch. But there are tradeoffs to consider, such as substantial upfront and ongoing costs and rules imposed by the franchisor on how you operate the business. And some franchise offerings are out-and-out frauds, so beware.
