Franchise Caught Your Eye? Better Check the Financials

McDonald's, Subway, 7-11, three-way split
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Many people who want to go into business for themselves choose a franchise because it's supposed to remove a lot of the risk. But a franchise can represent considerable risk itself.

If you're going to consider buying into one, whether a fast-food restaurant, hair salon, moving company, or fruit arrangement franchise, you need to go through the potential numbers with a fine-tooth comb. Here are some of the important points and warning signs you need to know.

Understand how franchising works

A central franchisor creates a concept in some industry and an approach to successful operations that is repeatable. You license a brand that might help bring customers in. More importantly, you gain access to a way to run a business that avoids many mistakes you might otherwise make.

For the right to use the brand and model in a given location or area, you pay money up front as well as ongoing payments. However, this is not a partnership. Even if the central company offers great advice and support (not all do), your business is independent. Mess up and the franchisor will not bail you out. This is important because you could spend hundreds of thousands of dollars and potentially even into the millions.

Start with the potentially right fit

%VIRTUAL-pullquote-The more you understand the particular type of business ... the better a chance you have of succeeding.%"One of the first things [potential franchise owners] should look at is what is their experience in this particular industry," said Candice Lee, a franchising attorney at the California law firm Palmieri Tyler. The more you understand the particular type of business from having been in something similar, the better a chance you have of succeeding.

Aziz Hashim, an experienced franchise owner who has been "in and out of 11 brands" goes further. "First you decide where your skill set, your interest, your passion lie," he said. "Then you try to identify a brand in that area. You have to pick one where you believe in the product and you believe that the unit economic model is one where you can actually make money."

"I've noticed there are trends and fads that come and go," said Eric Newman, executive vice president, general counsel and corporate secretary of Bojangles' Restaurants, Inc. and a lawyer with 30 years of experience in franchising. "If you have a concept that hasn't created its history yet, they don't know their challenges yet."

Some brands, including the one you choose, could fall to the wayside. In restaurants alone, such concepts as better burgers, bagels and rotisserie chicken have come and gone with many of the brands virtually disappearing.

The FDD is your friend

This is where the FDD, or financial disclosure document, becomes vital in your research. An FDD is a requirement that every state puts onto a franchisor.

The document is supposed to provide in one location much of the information about the particular franchise and its requirements that possible franchise owners might want, including the initial fees, ongoing charges, financial information about the franchisor and often (although not always) aggregated performance information for existing franchises.

An FDD can easily run hundreds of pages or more. You might be tempted to skip sections, but don't. You even need to check all the footnotes, as they can contain important details. Get a lawyer familiar with franchising to answer your questions, as you'll have plenty. Yes, it costs money, but not as much as losing your entire nest egg.

Look at how long the franchisor has been in business. Is this a new and risky concept, or one that has proven itself? Does the company own a good number of its own locations? If not, it is a red flag.

%VIRTUAL-pullquote-Concepts that have a significant number of their own corporate operating stores are voting with their checkbook.%"Concepts that have a significant number of their own corporate operating stores are certainly voting with their checkbook that the concept works and they bank on it," said Kevin Burke, managing partner of Trinity Capital, a 14-year-old investment bank that does a lot of work in large franchise transactions.

In the previous year's franchisor financials, look at the number of franchises at the beginning of the year, how many stores opened and closed and the total at the end. More stores closing than opening is a bad sign and could mean an intrinsically poor concept, bad real estate decisions or other indications of poor support from the franchisor, or the franchisor indiscriminately allowing people to qualify for franchises. Openings should be a "significant multiple" of closures, according to Burke. "Whether it's 3 or 4 or 5 or 6 to one, those should not be comparable," he said.

Know the franchisor business model

The FDD will explain in detail how the franchisor makes money. That is important because it is an indication of how much faith the company has in the concept.

The "classical" pattern, according to Newman, is that franchisors primarily made money from royalties and depended on the success of the franchisees. The more money paid for fees outside of royalties, the more the company may have effectively said that it can't make enough money from royalties because the franchisees can't make enough revenue.

%VIRTUAL-pullquote-Be careful of companies that insist franchisees buy all their supplies, goods, or equipment from them.% It's not always a problem. Hashim has a number of Subway locations and that company requires franchisees to buy meat from them.

"I can tell you it's impossible to beat their price on product," he said, although it always makes sense to see if there is better pricing available from other sources. "You can't take the risk that every franchisee is doing ad hoc purchasing," Hashim added. No one wants the chance of a public relations nightmare at one franchise that spills over by association.

That said, it should still be a red flag, although not an automatic veto. "It's too tempting to have that much cash flow running through your hands not to throw a nickel or dime on it," Burke said. "These companies get in trouble and then they start doing this. When they're out of trouble, they keep doing it. It's like crack; they can't get off of it." An example is the Quiznos chain that settled a large class-action lawsuit from franchisees claiming the company overcharged for required supplies.

%VIRTUAL-pullquote-If the litigation section of the Financial Disclosure Document is 15 pages long, that's a bad sign.%Furthermore, look at the litigation section of the FDD. This covers settling problems between a franchisee and the franchisor. "If the litigation section of the FDD is 15 pages long, that's a bad sign," Burke said. "You do not want a litigious franchisor. The agreement is already very one-sided."

Up-front costs

The FD will indicate the fees and charges you'll owe to the franchisor at the start, but they won't include other obligations for a new location, like fixtures, construction and paid training time for new employees. Michael Stajer is a former tech entrepreneur who owns 15 hair salon franchise locations.

"The number one thing I've learned is when you buy an existing unit from another franchisee, maybe someone who's retiring, the economics are a lot better than building new units," he said. You might pay three to five times actual earnings (profits). "Assuming in the hair business you've got a modest salon of $250,000 in gross sales and 10 percent profit, you're paying $75,000 to $125,000."

Get a new franchise location and the numbers change.

In the hair business, a franchise fee can run $10,000 to $15,000. Stajer has found that where he operates in northern California it can take 6 months to find good real estate. Then there is construction and creating the new location.

"In California, I tell you you're not building a hair salon for less than $100,000. My high end concept is closer to $175,000." And when you open, there is no stream of business the way you might have buying an established franchise. You have to plan for financing 9 to 12 months of losses as you establish the new business, because you will still need to pay rent, utilities and staff.

Don't forget your cost of living; if anything is tight, guess who won't get paid.

%VIRTUAL-pullquote-A franchise business like any business requires time to fulfill its potential.%"If you haven't built in 6 to 12 months of your living expenses, you may find yourself making decisions because you haven't built in enough time," Hashim said. "People think they will open the door and make money from day one. More often than not, a franchise business like any business requires time to fulfill its potential."

Investment may not end with opening, either. "The reality is if you're building a store of some kind, the reality is you could keep tweaking it and adding it," Stajer said. Franchisors might also change their look and require changes to décor, signage and lighting. "I think you should be as bare bones as possible. Put in the minimum installation and as small a space as you can." That way you minimize the costs and reduce financial pressure.

Also realize that the franchisor-provided projected ranges of startup costs, particularly in rent, construction and salaries, can underestimate actual costs in your area, particularly if you are in an expensive market relative to existing franchise locations. It pays to ask local contractors, real estate agents and others about whether the projections are realistic.

What are the operating costs?

Look at the unit level economics in the FDD. If the franchise omits that optional information, you can possibly get it by talking to actual franchise owners (more on that in a minute), but it's a big red flag. You want to see upper, lower and average or median figures for income and expenses. Even then, a single year can't reveal the whole truth.

%VIRTUAL-pullquote-A lot of franchisees just come in with the minimum requirements and they need to be conscious of the continual expense of startups.%"I do know that based on my experience, a lot of franchisees just come in with the minimum requirements and they need to be conscious of the continual expense of startups, whether advertising and marketing, hiring staff, having the ability to expand on the business," said James Miri, now a franchisor through Austin, Texas-based WG Storage & Delivery, but formerly a franchisee of a packing and shipping concept. "Based on my experience, I don't think that was emphasized enough [by the franchisor]."

Burke stresses the importance of the sales-to-investment ratio "litmus test." Divide the expected annual revenue by the up-front cost. A result of less than one is another bad sign. You need to have enough money coming in not just to create a sustainable business, but to justify your initial investment.

"Consider having an accountant to help with projections on how many customers they would need to bring in to make this a worthwhile business after they shave off the royalty fee, the initial franchise fee and all the other costs of being part of a franchise system," Lee said.

Call other current and former franchisees

Another important research step is to talk to other franchisees, both current and past owners. The FDD requires a list of literally all current franchisees and those that got out of the business within the last year.

Ask about such topics as the support system of the franchisor, how profitable they find their franchises to be, whether there are problems with the business model and if the prices of goods and supplies sold by the franchisor seem to be gouging.

%VIRTUAL-pullquote-Talk to every franchise owner you can, both current and former.%Don't call just a few. Newman suggests calling "every single one of them," assuming you're not dealing with a national chain with thousands of franchisees. "If you hear a trend like 'I wish I hadn't done this, I've never made money, no one makes money,' that will tell you more about the system [than the FDD ever could]."

A franchise can be a worthwhile business, but only if the particulars line up well with your business savvy, expertise, financial resources and interests. Hard research on the business model and financials can point to a winner, or warn you away from potentially losing everything you might invest.
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