Raising Entrepreneurial Capital Chapter 9: Franchising

Franchises are big business Franchises are very important to commerce--accounting for 45 percent of retail sales or $1.55 trillion in total revenue in 2010 Franchises exist worldwide. Ten percent of retail in the United Kingdom, France and Australia is carried out in franchises. Source: http://www.score.org/

More on financial impact Franchise businesses accounted for 10.5 percent of sales of businesses with paid employees in 2007.  Franchise businesses accounted for $153.7 billion in total payroll (about 10% of the amount for all businesses), and 7.9 million workers (about 13% of the workforce).

The successful franchisee Is somewhere between an entrepreneur and an employee. The hard work and drive associated with the entrepreneur are still needed for a successful franchise, but the typical franchisee neither needs, nor typically has, the vision and constant pursuit of new ideas typical of most entrepreneurs.

The franchiser The originator of a business concept or product. An entrepreneur who chooses to grow by leasing his or her idea to others, the franchisees, to penetrate the market and expand geographically faster than would be possible for the franchiser to do on his or her own.

The franchisee The operator, licensed to use the franchise name and operate under the rules and directives of the franchiser. The franchisee buys the right to use the franchise, typically for five to ten years. The agreement can be renewed but this arrangement provides protection to the franchiser against being saddled with a substandard franchisee.

Product/trade name franchises Grant the right to sell a product or use a trade name. Franchisee functions essentially as a distributor. Independent business benefiting from franchise-wide marketing efforts and name recognition and reputation. Largely auto/truck dealers, soft drink bottlers and gasoline service stations.

Business format franchise A complete business system. The franchisee acquires a proven business model, receives expert guidance and advice and usually has exclusive rights to a geographic territory. The franchiser realizes increased revenue and more rapid expansion than would be feasible otherwise.

Franchise agreement Establishes standards for the business. Operating systems, technical expertise, hiring guidelines and management methods are provided, and procedures are specified. The franchiser provides marketing, and often products, supplies and services. Training is provided both at start-up and on an ongoing basis.

Lowering the risk Brand name is well known and respected, positioning the entrepreneur in the marketplace. Think McDonald’s, Starbucks, etc. If the franchise has an established track record, the franchisee is purchasing a proven business model. Franchiser often provides help with site selection, facility layout, vendors and financing.

Failure rates While new business start-ups fail at a rate estimated in the 50% range during their first five years in business, the failure rate among new franchises is far lower. Some sources cite the failure rate as low as 5%, but it is important to note that this is the failure of the franchise not the franchisee.

Lowering operating costs Centralized functions that can achieve economies of scale are most efficiently carried out by the franchiser. Cost savings due to scale can be achieved, in purchasing and advertising for example, and passed on to the franchisee. Local site improvements are generally best carried out by the franchisee.

Drawbacks to franchising The franchisee must share the wealth through royalties and other fees and expenses, typically 3 to 6%. The amount of time and effort devoted to launching and running the business is similar to any other entrepreneurial venture but the entrepreneur relinquishes a degree of control and independence to the franchiser.

Costs to enter a franchise Vary dramatically by the type and market share of the franchise. Initial franchise fees, the cost to buy into the franchise, range from under $10,000 to hundreds of thousands. The average or typical initial franchise fee for a single unit is $20,000 to $35,000.

Want to own a McDonald’s? McDonalds charges a $45,000 franchise fee, this is only the initial fee for licensing rights. Other start-up costs include real estate, inventory, equipment, employee training, etc. Total cost to open a McDonald’s is likely to be over $1 million.

Financial requirements An initial down payment is required when you purchase a franchise outlet. For a major franchise this could be on the order of $300,00 to $ $500,000 The down payment must come from non-borrowed personal resources. Cash flow is likely to be tight in the first year or two and cash demands could push the franchise into unprofitability or worse.

Due diligence and the FDD The Franchise Disclosure Document (FDD) is the format for disclosing franchisor information to prospective franchisees. It is required by the FTC. This document, which must be supplied by the franchiser, is essentially a prospectus describing the business and the opportunity.

More due diligence Interview several current franchisees and as many as feasible of the ones who have left. Find out the reasons that those people leaving the system left. Ask current franchisees whether they would invest in this franchise if they had it to do over. Ask about profitability and time to break even for their franchise.

Franchiser financing Many franchisers provide financial help in some way. Often it is through an established relationship with a lender. Frequent lender is familiar with the business model and the cash flow needs of the franchise at start up. Some franchisers provide financing themselves, and some obtain financing on behalf of the franchisee.

SBA financing The U.S. Small Business Administration has been guaranteeing loans for franchisees since 1993. Franchisers may register with the SBA Franchise Registry. This is optional, and does not convey approval by the SBA, but is a mechanism to expedite financing.

SBA financing advantages SBA loan guarantees can cover up to 85% of the loan amount. Loans are made for general purposes, including the franchise fee, and for real estate acquisition. The Franchise Registry provides a list of approved franchises: http://www.franchiseregistry.com/registry/ About 10% of all SBA loans go to franchisees, with the size running between $250,000 and $500,000, and a maximum of $2 million.

SBA terms The SBA prefers that the borrower have 30% of the franchise fee in cash before a loan is granted. The loan applicant must still comply with the SBA’s requirements for experience, financial resources, character and capacity to repay.