An interesting young company offering franchises for the first time might sound like a sexy opportunity, but buyer beware. With franchising, you are buying into a proven business model – it’s one of the key benefits of franchising. Because 70% of startup companies fail, your risk rises fast with younger companies.
We chatted with George Ray, a franchising specialist at Florida SBDC at FIU, the small business development center within the university’s College of Business, about how finding the best franchise opportunities begins with your own due diligence. So where do you start?
You are buying into a business concept that has proven profitable but some franchisees have not achieved regional or national brand recognition, even though they may try to pass themselves off that way, cautioned Ray, who consults with startup businesses and franchisee clients through SBDC. These young busnesses may have a few stores open but if they don’t have franchises operating in multiple territories for at least five years, it’s not a proven model.
Companies that don’t have a track record of at least 5 or 10 years in franchising can’t project what your average revenue will be, Ray continued. They will give you average revenue projections based on their top 25 stores and that is hard to do if you haven’t been around that long.
While there are many benefits of franchising, “don’t buy into franchises that haven’t achieved national or regional brand recognition,” Ray cautioned. “You are taking a lot more risk if you do.”
Here are three common pitfalls to watch out for.
1. You may not get the technical training and support you need.
A good franchise will offer at least two or three weeks of education and training at its headquarters and another three months of close monitoring during your initial launch as well as some onsite technical assistance by an experienced operations manager, Ray said. In some cases, the company will help you with the hiring and training or place an experienced unit manager to help you initially with operations to help ensure success. There is a lot of value in this service because it can significantly reduce your risk exposure, Ray said.
“Buying into franchises that are relatively new might sound trendy but can also increase your risk exposure if they don’t have training, support and great brand recognition,” Ray said. “Having a franchise that offers great technical support may be the difference of you surviving or not.”
2. Territories matter. Are you being set up to fail?
Ray knows franchise owners who have experienced this: Your numbers are high so a franchisor allows another franchisee to open up near you or may even open a corporate store close by, cannibalizing your sales. What’s more, they could not renew your franchise agreement once you have built out the territory and made the location very profitable – and then convert it into a corporate location. He’s heard of that happening too.
To avoid these scenarios, you’ll want to interview multiple past and present franchise owners – not just the ones that the franchise company sets up for you. Do your own due diligence. And for territory agreements, you should try to negotiate with the franchise in your best interest. It’s not one-size-fits all, but you need to be aware of these possible scenarios.
3. Hidden fees add up.
Look out for hidden fees that are not advertised. Some franchises come with technology fees to use their POS system, leasing fees on equipment, or advertising – they all have different fee structures. You can find these in the FDD (franchise disclosure document). For one of Ray’s clients, he added them all up and it was 17%, a red flag.
“Most fees are standard in the contracts, however in business everything is negotiable if you do your research. I always tell clients ‘Life is not about what you get but what you can negotiate.’ This is why due diligence is so important when you are trying to find the right franchise to invest in. Read the small print on the lease equipment. Some franchisees make you buy all of your supplies and food from directly from them at a marked up price,” said Ray. “These fees all add up and if it’s more than 10% you might want to think twice about the unit you are buying. Don’t let them fee you to death.”
If you uncover some unfavorable fees or practices, you should be ready to negotiate a more favorable deal. Ray helped a franchisee negotiate a deal to pay their franchising fee over a two year period, as part of a takeover deal.
Above all, do your own due diligence, Ray said.
Carefully read the FDD, which typically includes audited financial statements, a breakdown of start-up and ongoing costs (add them up), and an outline of your responsibilities and the franchiser’s obligations.
Then interview at least 10 current and former franchise owners. Typically, names and phone numbers of former as well as current franchisees are listed in the FFDs. Among your questions, ask them about the training and support they received, unseen costs, expectations vs. reality, competition, and whether in hindsight they would invest again. Contacting some former franchisees and asking why they’re no longer in business could save you from a similar outcome.
Take your time with your research. If a seller tries to get you to invest as quickly as possible, it may be a red flag you should heed.
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