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Five Steps of Franchising

The Process of Buying a Franchise

The history of franchising goes back to the Middle Ages but it reached its economic apex in the 1970's in the United States. Franchising has been enjoying a resurgence that started in the late 1980's. The success of franchising has attracted some inexperienced and occasionally fraudulent franchisors. In 1979, the federal government implemented a law to protect consumers from fraudulent franchisors. However, the old Latin saying, "caveat emptor", or "let the buyer beware", still applies when it comes to buying a franchise.

How to Evaluate the Right Franchise Buying Opportunity for You

Before you buy a franchise or start selecting a home based business, we have outlined a simple process for evaluating a franchise buying opportunity. The process is not foolproof, and as the history of franchising has proven time and time again, misjudgments can still occur. However, following the process will help you avoid disastrous mistakes made by many other people buying into a franchise. The five steps which are explained will assist you in buying into a franchise or selecting a home based business that is a suitable match for you and has the potential for financial success.

 

Step 1 - Examine Your Opportunities

Most franchise owners find their dream franchise opportunity in a business directory. There are hundreds of franchises listed in the franchise directory. In most types of businesses, you will find several franchise opportunities. Each business category has its own franchising directory. For example, if you have an interest in a donut shop, you will find many franchisors who offer the opportunity to own and operate a donut shop in a fast food franchise business directory. There are many franchise directory categories you can use to expand your franchise research, plus some magazines that periodically publish franchising directory lists of franchisors. You will want to use a franchise business directory to contact and compare all possible franchise choices. The franchise research you will gain from a franchising directory will allow you to review the costs and benefits for each franchisor. You will probably want to narrow the possible alternatives to a finalist group of no more than five. This group of finalists should represent those that you want to consider seriously. If you think you have identified your dream franchise opportunity in a business directory, we recommend that you complete Steps 2-5 for each franchisor.

 

Step 2 - Examine the Franchise and the Franchisor

It is important to obtain a thorough financial disclosure statement from your franchisor before beginning your franchising opportunity. In fact, the federal government and several states have laws stipulating the information that a franchisor must provide in their financial disclosure statement. The financial seller disclosure statement is sometimes referred to as a Uniform Franchise Offering Circular (UFOC). The following list contains the twenty items of information that must be in your Uniform Franchise Offering Circular statement.

The seller disclosure statement must include:

  • Information identifying the franchisor and its affiliates and describing their business experience.
  • Information identifying and describing the business experience of each of the franchisor's officers, directors and management personnel responsible for franchise services, training and other aspects of the franchise program.
  • A description of the lawsuits in which the franchisor and its officers, directors and management personnel have been involved in the franchising opportunity.
  • Information about any previous bankruptcies in which the franchisor and its officers, directors and manage ment personnel have been involved.
  • Information about the initial franchise agreement fee and other initial payments that are required to obtain the franchise.
  • A description of the franchise agreement conditions under which the franchise may be repurchased or refused renewal by the franchisor, transferred to a third party by the franchisee, and terminated or modified by either party during the franchising opportunity.
  • A description of the continuing payments franchisees are required to make after the franchise opens.
  • Information about any restrictions on the quality of goods and services used in the franchise and where they may be purchased, including restrictions requiring purchases from the franchisor or its affiliates.
  • A description of any assistance available from the franchisor or its affiliates in financing the purchase of the franchise.
  • A description of restrictions on the goods or services franchisees are permitted to sell.
  • A description of any restrictions on the customers with whom franchisees may deal.
  • A description of any territorial protection that will be granted to the franchisees.
  • A description of the training programs provided to franchisees regardign the franchising opportunity.
  • A description of the involvement of any celebrities or public figures in the franchise.
  • A description of any assistance in selecting a site for the franchise that will be provided by the franchisor.
  • Statistical information about the present number of franchises, the number of franchisees projected for the future, the number of franchises terminated, the number of franchises the franchisor has decided not to renew and the number of franchises repurchased in the past.
  • The financial statements of the franchisors.
  • A description of the extent to which franchisees must personally participate in the operation of the franchise.
  • A complete statement of the basis for any earnings claims made to the franchisee, including the percentage of existing franchises that have actually achieved the results that are claimed.
  • A list of the names and addresses of other franchisees within the franchising opportunity system.
  • A franchisor may want to conduct a preliminary approval of you before providing this information. The law stipu lates that the information must be provided before you sign a franchise agreement. Further, you must be given a chance to review this information without interference from the franchisor. The sooner you have this docu ment, the sooner you can begin your screening process. Do not be reluctant to let a franchisor know that you are reviewing this information and comparing it with competitors. Franchisors that are upset with this approach and unwilling to do business in this manner are probably not the kind of organization with which you want to be associated. A strong franchisor is not afraid to compete directly with rivals at any time during the franchising opportunity.
 

Step 3 - Analyze and Evaluate the Disclosure Statement

Not only do you want to own and operate your own franchise, you want your business to be the most successful franchise operation on the block. However, there are a lot of things to analyze and evaluate first before making a final decision, such as franchise advertising, years of operation, franchise profits and so on. So-where do you find out such information? Information contained in the disclosure statement provides a basis for thoroughly analyzing the potential for a franchise. However, it is also necessary to investigate the franchisor to ensure that all information is truthful and accurate. Note the following points about this step:

1. Points to consider about the franchisor and the small business franchise.

Experience of management and directors. The experience of both the management and the directors is critical to a successful franchise. These individuals should have sufficient experience that they can add significantly to your own business expertise. The most successful franchise owners have special knowledge and understanding about the type of business operation they are selling, as well as a targeted franchise advertising plan.

Number of franchises in operation. The number of franchisees provides some measure of the stability and experience of the franchisor. It is possible that a new franchisor provides a great ground floor opportunity. However, your risk is reduced when you select a franchisor that has more than one small business franchise location under their belt. Each franchisee provides the franchisor with added experience in starting a new franchise location. This combined experience will prove highly beneficial in getting a successful franchise started.

Franchise profits. The certified financial statement provided by the franchisor should indicate whether or not the business generates healthy franchise profits. If you question the businesses franchise profits, you might want to reconsider developing an association with the franchisor.

Number of franchises no longer in operation. You need to find the number of franchisees who have been closed or repurchased by the franchisor, or gone out of business. This information can be even more important than the number of currently operating franchises. Franchisors will sometimes buy out or close unsuccessful franchisees in order to remove problems. It is important to know how many situations like this have occurred. The more franchisees that have experienced problems, the greater your risk becomes in purchasing a franchise.

Years franchisor has been in operation. The length of experience often indicates stability and a higher potential for franchises to succeed in the future. However, there are some good opportunities with younger franchisors. Do not let this factor alone discourage you from considering an association with a franchisor.

Type and amount of training. The type and amount of training the franchisor provides can prove critical to your success. The best training programs will include a combination of classroom training and on-the-job training. There should be a few weeks of training involved for it to be highly effective.

Type of management assistance provided. There should be a large amount of assistance provided with the start-up of the small business franchise. This period of time is normally the most difficult and requires the greatest amount of assistance. However, there should be continued assistance offered regularly, as well as for unexpected crises.

Assistance in financing. Determine the assistance that the franchisor can provide for financing your business. Will the financing include the franchise fee, equipment, building, supplies and operating capital? A less reliable franchisor may not obtain financing that will be most beneficial to a franchisee. Be sure to carefully examine the interest rate and loan conditions and have them reviewed by a professional attorney or an accountant.

Site location assistance. An old expression about retail establishments states that there are three critical elements to business success: location, location and location. While this is an exaggeration, it illustrates the importance of site location. An experienced franchisor should be able to provide sophisticated techniques for accomplishing this task.

Planning and constructing a building. Assistance in constructing a building can help you save a great deal of money. Find out whether there is any additional fee for this assistance.

Reputation among franchisees. The franchisor's customers are its franchisees. The best way to determine how you will be treated as a customer and a franchisee is to talk with other franchisees. If possible, try to talk with those who are no longer in business. They can offer a unique insight into franchisor treatment and services.

Projected operating losses. Determine how long a small business franchise is expected to operate before revenue will be sufficient to cover expenses. This will help you calculate the amount of funds you will need to raise in order to cover this deficit.

Potential profits. A critical element in deciding about a franchise is the amount of annual profits that you can expect. Have a cost analysis done to determine whether the projected profit is enough to ensure a reasonable return on investment. You should ask other franchisees whether the profit they make each year is close to what the franchisor told them to expect. Project the length of time that it will take to recover your initial investment.

2. Points to consider about personal needs.

Equity requirements. The franchise fee and the capital investment requirements are the biggest obstacles for most potential franchisees. Once you determine your net worth, discuss it with a banker to determine an amount of money that you can borrow. (There are other ways to raise capital, but a loan is perhaps the most common way of financing a franchise.) This information can be used to quickly eliminate those franchisors whose equity requirement is more than you can comfortably finance.

Interest and enthusiasm. A franchisee needs to be excited and enthusiastic about a franchisor's product or service. There are several reasons for this. One, you will be associated with the franchisor for many years and need enthusiasm for motivation. Also, your attitude toward the franchisor will be sensed by your customers and employees. Your small business franchise customers will be more likely to patronize your business when they observe your enthusiasm. Likewise, employees will work harder when they are inspired by your excitement.

Business skills. The franchise should closely match your business experience and skills. The more you know about the business operation, the higher your potential for success. This does not mean, however, that you must have experience with the specific product or service. You should expect the franchisor to provide training and management assistance, but related skills and experience will help significantly.

3. Points to consider about market viability:

Community fit. Many products and services can be successful in one geographic area but may not work well in another. Customs, tastes, traditions, wealth and other factors affect the success of a product or service in a community. Franchisors will sometimes conduct a market survey to determine the franchise's viability for your community. However, you need to verify the accuracy of such a study. Less honest franchisors may attempt to modify the survey's outcome to use it as a selling point.

Location availability. The importance of small business franchise location has already been mentioned above. You need to consider how critical location would be to this particular business. Next, it is necessary to determine whether a location suitable for the business exists within your community. If you have doubts about available sites, you should reconsider your investment in the franchise.

Longevity of product. To protect your investment, the franchise should have long-term staying power. Ask yourself whether the product or service is faddish. To do this, it is often necessary to look past your enthusiasm and be objective about the product or service. Ask the advice of experienced business people. Talk with friends who would be typical of your future customers. These combined opinions will help you predict the product's longevity.

Population stability. Find out the population projections for the community in which you plan to place the small business franchise. City government, chamber of commerce, Small Business Development Corporation, economic development commission and other sources can help provide this information. The long-term growth of the population will have a significant effect on the franchise's potential success.

Competition. Study the competition that will compete directly against the franchise. Then study indirect competition. For example, a specialty coffee shop might compete against delis, gourmet shops, etc.

Price. The price for the product or service should be consistent with average incomes for people in your geographic area. A high-price product will sell in an area where income is high but would probably be a loser in an area with low-income households.

Advertising. Find out how much advertising the franchisor does on a local, regional and national basis. This is very important when you consider the value of a franchise. A franchisor with a less expensive franchise fee may lower operating costs by limiting its advertising. This may hurt your franchise sales and business growth.

Advertising campaign effectiveness. The franchisor's marketing expertise is very important to your success. You should expect the franchisor's help in generating sales. A franchisor should offer effective advertising tools that include the creation of newspaper, radio and television advertisements. These should be professionally prepared along with a marketing strategy that will maximize their use.

Cooperative advertising. Most franchisors require the franchisee to pay cooperative marketing fees. This is typically a percentage of small business franchise revenues. It is important to understand how this money will be used and what impact it should have on your franchise.

 

Step 4 - Investigate the Franchisor

It is important for you to investigate the franchisor thoroughly. You wouldn't want to start a business opportunity with someone you didn't know or trust. Consider your relationship with the franchisor a partnership and check the franchisor out completely. There are three stages to this investigation. Beware of any franchisor that wants you to make a decision so quickly that you will not have time to go through the following investigative process.

1. Investigate the credibility and reliability of the franchisor. This is particularly critical with franchisors that have been in operation for a short time. Information from sources such as the Better Business Bureau and Dunn and Bradstreet can tell you a great deal about the franchisor. Try to find a person or company who will run a credit check on the organization. If the franchisor is a smaller and less-well-known company, you may also want to conduct a background and credit check on the management and corporate officers.

The disclosure statement must include information about lawsuits. If there are lawsuits pending against the franchisor, investigate these by contacting the attorney for the plaintiffs. Ask the attorney to explain anything he or she can about the lawsuit. Question the franchisor about what the attorney tells you. You should feel comfortable that the lawsuit is about an issue that would not affect you.

2. Talk with franchisees about their experience. The disclosure statement is required to have a list of franchisees. Pick a group of franchisees at random to contact. Your conversation with franchisees can provide important information about the business opportunity. Some questions to ask are:

  • Did the franchisor follow through on its promises?
  • Does the franchisor provide good management assistance?
  • Does the franchisor provide good marketing and advertising programs?
  • What are the strengths of the franchisor? What are the weaknesses/
  • Do you consider your franchise to be a success? What has contributed the most to this success?
  • Did the franchisor make any mistakes during the start-up? How could the mistakes have been avoided?
  • Have there been management and operational mistakes? How could these have been avoided?
  • How strict is the franchisor about business being conducted exactly as described in operating manuals?
  • If you could do anything over again, what would it be?
  • Would you recommend that a person buy this franchise?

Carefully review the answers that you get. Are there consistent problems or concerns raised by the franchisees? A consistency indicates a pattern which increases the probability that the problem will be repeated with your franchise. Likewise, positive answers should encourage you to seriously consider entering into an agreement with the franchisor.

3. Seek the advice of professionals about the franchisor and franchise agreement. Three professionals that you should definitely confer with are an attorney, an accountant and a banker.

An attorney is needed to review the franchise agreement and business opportunity. This is your contract with the franchisor and provides the only written commitment and promises that exist. Anything that has been verbally promised should be in this agreement. The attorney and you should review the following items in the agreement:

What is the length of the contract? It should be the same length discussed with the franchisor.

Does the contract provide an exclusive territory? If not, what protection is offered against other franchisees taking business away from you? Proliferation of franchisees can seriously erode your revenue. This is the reason that you need some protection.

Are there restrictions on selling the franchise? The more limitations that exist, the more difficult it will be for you to recover your money. Many franchisors will offer to buy back the franchise, but there are often conditions. You need to have a clear understanding of what you must do in order to initiate the buy-back provision.

What are the criteria you can use to cancel the contract? Likewise, what are the criteria the franchisor can use to cancel the contract? These criteria should be reasonable and provide a clear process for canceling the contract.

Does the franchisor agree to buy back the franchise if the contract is canceled? This is absolutely necessary or you risk losing all of your initial investment in the business opportunity. Furthermore, determine whether the franchisor will compensate you for the goodwill built during your operation of the franchise. Goodwill is a valuable asset and takes a significant investment of time and effort to accumulate.

Are there any franchise requirements that you believe are unwise, illegal or unethical? Sections of a contract that make you uncomfortable at the start of a business relationship may result in problems at a later date. You will probably feel uncomfortable implementing a provision that you don't believe is right.

Has the attorney identified any problems with the contract? There are a number of legal technicalities connected with most business contracts. An experienced attorney will be able to advise you about these provisions.

An accountant should review two primary items for you. First, the accountant should examine the corporation's financial information that is provided in the disclosure statement. Second, the accountant should review the financial potential of the business. You should ask the accountant the following questions:

Is the initial investment for the franchise fee, equipment and building reasonable? The accountant may be familiar with fair market value for these things or should be able to obtain this information.

Are the royalties and cooperative advertising rates regarding the business opportunity reasonable? There are ratio tables that illustrate typical expenditures for certain categories of business. The tables can be used to indicate whether the rates being charged by the franchisor are within a normal range.

What will your financial situation be during the first five years of operation? A form that is often used in a business plan is a financial proforma. The financial proforma is a five year financial plan. The plan includes projections for income, expenses, cash flow and profits. Review this plan with your accountant and determine the potential return on investment for the franchise.

Is the investment a reasonable risk? All new businesses are risky. However, you must balance out three key areas to determine the degree of personal risk. These include your personal assets, resources for financing the franchise and the potential return on investment. You should be able to afford any loss to your personal assets. The financing should provide a monthly repayment schedule that is reasonable and affordable. Potential return on investment should directly correlate with the risk that is involved.

A banker should be contacted to review the business opportunity, the financial proforma and your persona financial statement. The banker can provide insight into the financing issues that will be involved. The banker needs to answer the following questions:

Would the bank consider giving you a loan to finance your business? (This question can be directed to your accountant as well to determine how affordable the purchase is for you.) The banker's answers are given from a lender's viewpoint. When a bank turns you down for a loan, the loan officers note the problems. Ask the loan officers to fully explain the reasons for not making the loan. This information will allow you to evaluate for yourself whether these are serious problems that could impede the franchise's success.

Do the loan officers feel that the franchisor is credible? The bank will take more risk when your personal assets are sufficient to underwrite the loan. This doesn't give you any assessment about the franchisor or the franchise agreement. Make sure that the loan officers provide a compete explanation of the loan review board's evaluation about your potential for success. What strengths and weaknesses do they judge the franchisor to possess?

What are the lending conditions of the business opportunity? These conditions, including the interest rate, provide additional information that can be used to assess the viability of the franchise. More liberal conditions indicate a more positive evaluation of the franchise by the loan officers. Also, attractive conditions will increase your profit potential.

You should weigh the review and recommendations of all three professionals before you make your final decision about a franchise. These experts can provide important advice, and you should value their opinions.

 

Step 5 - Make a Decision

As with all decisions, this is usually easier said than done. Many questions have been presented above which need to be investigated. Sometimes you will discover positive facts about a franchise, and sometimes you will discover negative facts. It is possible that the positive or negative facts will be so one-sided that it is simple to make a decision. However, it is more typical to find that the facts must be organized in a manner that facilitates the franchise buyers decision-making process.

A simple but effective decision-making approach is the "T" method. To follow this method, you make a "T" on a page. On the left side of the "T", list all the positive reasons for buying a franchise, and on the right side, all of the negative reasons. Once the two lists are completed, assign each item a number to designate its importance. A simple scale of 1 for "unimportant", 2 for "somewhat important" and 3 for "very important" can be used. Total the numbers for both sides. The larger the numerical difference between these totals, the more sure you can be of your decision. Totals that are close will make it more difficult to decide. However, an investment of this importance should usually be one that makes you feel confident of success. After completing the "T" method exercise, you should feel certain that your decision is correct. A decision to buy a franchise should result in enthusiasm for the undertaking. Without dedication and enthusiasm, you may find it difficult to achieve success.

The "Five Steps of Selecting a Franchise" were designed to provide a basic introduction to the concept of franchising, including its advantages and disadvantages. This information should help guide you in your decision-making process about purchasing a franchise. Good luck!

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