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What You Need to Know About Franchises

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Buying a franchise can be a very smart decision for entrepreneurs. Instead of building a business from scratch, you get access to the brand recognition and marketing clout of a more established business, as well as a template for running the franchise profitably.

But it’s also possible to lose a lot of money if you rush in and buy without fully understanding what you’re getting into. The salespeople might make a franchise sound like a rock-solid investment opportunity, but remember that it’s their job to make it sound that way. Your job is to do the necessary research so that you can make your own fully informed decision.

In this series on buying and running a successful franchise, we’ll show you exactly what research to do, and how to do it. You’ll learn how franchises work, how to find good opportunities, how to evaluate a franchise (including an in-depth look at the disclosure document and franchise agreement), and how to run a franchise successfully. By the end, you’ll be in a good position to invest with confidence.

In this first tutorial in the series, we’re going to focus on the basics of franchises—what you need to know about them before you even start the process of looking for investment opportunities.

You’ll see how franchises work and how they differ from independent businesses, the pros and cons of franchises, and how to decide whether the franchising model is right for you. Buying a franchise is a major commitment, both of money and time, and it pays to have a solid understanding before you invest.

Step 1: How Does a Franchise Work?

Let’s start with the basics. What is a franchise, and how does it work?

If you want to run a convenience store in your town, you could do it a couple of different ways:

  1. You start your own business from scratch, say Dave’s Convenience Store. You rent a space, create your own business plan and advertise to build up name recognition slowly.
  2. You go through a well-known brand like 7-Eleven. In return for a fee, you get the right to use a brand that customers instantly recognize, and follow a business model that’s been used by thousands of other stores around the world.

As you may have guessed, the second option is franchising. In this case, 7-Eleven is the franchisor, and you are the franchisee.

Although 7-Eleven is a well-known franchisor, there are many others, including household names like McDonalds, Subway, Comfort Inn and H&R Block. Altogether, there are more than three quarters of a million franchise businesses in the U.S., employing 8.3 million people and generating $802 billion in revenue.

The details vary greatly from franchise to franchise, but in a typical deal you’ll sign an agreement for a term of 10 years and pay a fee of $20,000 to $35,000, as well as committing to pay royalties of perhaps 5% of revenue every year.

You’ll also have to budget for the usual setup costs of a business, like rent, equipment and inventory, so the overall startup cost is usually somewhere between $50,000 and $200,000. For some businesses, though, it can run into millions of dollars.

The franchisor will often give you training and support in finding the right location and setting up your store, and in many cases you’ll get marketing plans, operating manuals and other materials to give you direction.  

Once you’re up and running, you operate the business yourself and keep any profits you make (after paying royalty fees, of course). You’ll have managerial discretion in some areas, but in others you’ll have to follow the guidelines established by the franchisor. All of this will be laid out in the franchise agreement you sign at the outset—we’ll have lots more on this in the 4th tutorial in the series.

Step 2: The Benefits of Franchises

Here are some of the advantages of running a franchise, as opposed to going it alone:

Brand Recognition

Buying a franchise can give you access to some of the most well-known brands in the world, and that’s a big advantage. Usually in business, it takes a long time to build up a reputation—even in your local area, let alone nationally. With a franchise, on the other hand, you get instant brand recognition and a ready-made customer base on day one. People might hesitate to try Dave’s Convenience Store for the first time, but with 7-Eleven or another major brand, they know exactly what to expect.

Economies of Scale

Everyone knows that large companies have more bargaining power than small businesses. As the owner of Dave’s Convenience Store, you’ll have to negotiate your own terms with suppliers, and they likely won’t be as favorable as the ones enjoyed by 7-Eleven.

Proven Business Model

When you buy a franchise, you’re buying into a system that’s worked for hundreds or even thousands of other franchisees. Nothing is guaranteed, of course, and you should beware of hype: some research suggests that the success rate of franchises is no better than that of independent businesses. Nevertheless, using a business model that’s worked for others should give you some comfort.

Training and Support

The level of support you get varies by franchise, but you can expect some training, marketing help, and access to a business plan. Often you’ll get advice on laying out the store, guidance on operating procedures, and ongoing supervision and managerial support. This can be a big help, especially if you’re new to running a business, or if you’re switching to a new industry.

Full Disclosure

When you’re buying a franchise, you have access to a lot of information on what it will cost and how the deal will work. As we’ll see in later tutorials in this series, you have to do some extra legwork not just to understand the Franchise Disclosure Document (FDD) but also to ask questions, interview other franchisees and so on. But if you do your research, you can get a good estimate of what you’re letting yourself in for, whereas starting up by yourself can be more of a leap into the unknown.

Step 3: The Disadvantages of Franchises

There are, of course, some trade-offs involved. Here’s a rundown of some of the disadvantages of franchises.

Lack of Control

Think about all the McDonald’s restaurants you’ve been to over the years. There might be some minor differences in how they were laid out, but they were basically all the same, weren’t they? Same menu, same food, same packaging, same pickles.

The uniformity is an advantage, as we noted above, because it helps customers know what to expect. But it also seriously limits the independence of each individual franchisee. As an independent business owner, you can tweak your product offerings to your heart’s content, experimenting to find out how to give your customers exactly what they want. With a franchise, you’ll often find yourself with some strict rules to follow.

Reputation Risk

The lack of control applies to reputation, too. If you’re running Dave’s Convenience Store, you and your staff are entirely responsible for the customer’s experience, and so have some control over your reputation. With a franchise, on the other hand, mistakes made by the franchisor or by other franchisees can leave customers with a bad opinion of your store, through no fault of your own.

Limited Time

Franchise agreements usually run for a long time, often ten years. But what happens after those ten years are up? You may be able to renew, but there’s no guarantee. And if you violate any of the terms of the agreement, the franchisor may even terminate it early. Whereas an independent business owner can continue indefinitely if the company’s making a profit, a franchisee can’t always do the same.

Diluted Rewards

When you start your own business, you’ll often have to work incredibly hard, but you know that all that effort is generating rewards for you and you alone. Every customer you make happy is a repeat customer for your business. If you manage things well, you may soon be able to open up new branches, expand, and maybe even hit the big time. Whole Foods Market started as a single health food store in Austin, Texas, and is now a multi-billion-dollar corporation.

When you buy a franchise, on the other hand, the rewards don’t all go into your pocket. Customers associate your store with the overall franchise, so the hard work you put into pleasing them benefits the franchisor or other franchisees as well as you. You’re building someone else’s reputation, not your own, and while you may run the franchise successfully and make substantial profits, you’re unlikely to become the next Whole Foods Market. And don’t forget that you’ll usually pay a percentage of revenue to the franchisor.

Step 4: Is a Franchise Right for You?

So which is better? Starting up your own independent business, or buying a franchise? The answer is that it depends entirely on you. For some people, a franchise is a great option; other people would be better off going it alone. Here are some questions you can ask yourself, to help you decide whether franchising is right for you.

Can I Follow Someone Else’s Rules?

Here’s the paradox involved in franchising. Buying a franchise is often marketed as a way to achieve independence and be your own boss. But in fact, as a franchisee you often have little independence. You’re told which products to sell, and how to sell them.

That’s great if you want the structure and support, but it could become very frustrating if you’re the sort of person who likes to do things your own way.

Think back to that McDonald’s restaurant. How much scope is there to put your own stamp on the place? Do you think they’ll let you get creative with the Big Mac recipe, or give the golden arches a makeover? Good luck with that.

Bottom line: If you’re good at following rules, and you like order and structure, you’ll likely make a great franchisee. If you see yourself as an innovator, you’re probably better off with the freedom of running your own show.

Am I Good With People?

Franchisees typically have to be “hands-on” managers. Since the business model is provided, and many of the executive decisions are made for you, what really determines your success is how well you manage the franchise—and a big part of that is managing people. Also, many franchises are in the retail industry, so you’ll be dealing with customers all the time. Ask yourself how good you are with people, and whether you like having that much contact.

How Much Experience Do I Have?

Have you ever run this type of business before? Have you ever run any type of business before? What other skills and experience do you bring to the table from your previous career?

If you’re an industry pro, and feel confident in your ability to run a profitable business, then going it alone may make more sense. You’ll be able to do things your own way, implement your own ideas, and keep all the profits. You don’t need guidance and training from a franchisor.

If your experience is more limited, however, the extra support provided in a franchise arrangement could really help. Instead of having to figure everything out by yourself, you can take advantage of the franchisor’s training and recommendations, and use the products supplied to you instead of having to decide what to stock yourself.

If your experience is very limited, then think very carefully before making a major investment, either in your own business or in a franchise.

How Does It Fit In With My Life?

Running a franchise is a huge commitment, and if you’ve never done it before, it could be very different to the lifestyle you’re used to. Ask yourself if your family situation will allow you to devote the time and energy needed to make the franchise a success.

Also look at your finances. Being able to afford the initial franchise fee is not enough. There’ll be plenty of other costs and uncertainty along the way, so be sure you have a financial cushion.

Next Steps

Now that you’ve learned the basics of franchising, how it works, and some of the pros and cons, the next step is to start looking for good franchises to run. In the next tutorial in this series on buying and running a successful franchise, you’ll get a step by step guide on deciding what sort of franchise you want to manage, and finding the best opportunities.

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