By: Dennis Zink
July 19, 2019
In this interview, I will be exploring the benefits of Buying a Small Business, specifically a franchise business. However, we will compare franchise and non-franchise businesses. We will look into the types of local small business franchises that are available. We will help you understand how to choose the best fit while we review the costs of buying and operating within a franchise system versus Buying a Small Business that is not a franchise.
Jenny Sutter is a franchise consultant and owner of FranNet, a franchise itself. FranNet is a national SCORE partner helping entrepreneurs find the best franchise fit. Our other interviewee is Bob Melberth. Bob is a SCORE mentor and a franchising expert having worked for McDonald’s, Wendy’s, Popeyes, and Beef O’Brady’s. He’s also owned three franchises.
A franchise is essentially the right to use a brand name, trademark, business services or products, marketing structure, training structure, business processes in exchange for a franchise fee and ongoing royalties.
I think from different points of view, from the franchisor or licensor’s point of view, franchise is governed by the Federal Trade Commission, where a license agreement is governed by contract law. The aspect from a franchise purchaser or business purchaser is a franchise is going to be a little more restrictive in terms of its structure following the rules that the franchisor establishes. That license agreement, the licensee pays a one-time fee and perhaps some override on a product that they control and distribute themselves.
There’s quite a few of them. The biggest misconception is that they are expensive. Another is that they’re only fast food or retail. There’s a lot of different franchises in a lot of different industries, those are the two biggest.
There was a study done by the U.S. Chamber of Commerce that showed over a 10-year period of time that 93% of the franchises were still in business 10 years after they started as opposed to about 25% of non-franchise businesses.
Each franchise is a little bit different in how restrictive they are as to the process, but essentially you do have to follow their process, their rules and regulations. For some emerging franchises there is a little more leeway to have your opinion on how things should be run.
You should talk to the franchisor about whether it’s something they want to create as part of their process.
I think the key point is that a restaurant is a little more replicable. The franchisor can have a lot of control over menu, pricing, etc. There are advantages of being able to purchase for a chain. Your costs of being in business versus a local single-operator’s would result in a lower cost of goods. I think primarily that most people associate the big names and I’ve worked for a couple, McDonald’s, Wendy’s, etc. with franchising. It’s a popular opinion. The International Franchise Association says that there is about 97 different industries that franchise their business concepts.
It comes down to personal fit. A restaurant is not going to be for everyone. They’re seven days a week generally and not everyone wants to work seven days a week. Does it meet their budget needs? Does it meet their income needs? Is it going to meet their personal leisure needs or personal project needs? It really does need to be a fit with the individual and what their goals and motives and values are.
Newer franchises could be low, and it can get up into the millions of dollars. A general range is between $50,000 and up to a million. That’s not to get into the franchise. That’s to get a franchise up and running. The only difference between that and if you would start your own business would be the franchise fee.
For the franchisor, the most profitable way for them to grow is to grow with existing franchisees. Some people approach the marketplace saying that we’re going to sell a package of three stores or five stores or 10 stores at a time. That’s not the case with all franchises. A lot of franchises will only allow you to purchase one, and then if you’re successful with that and you’re the kind of community of franchisee partners that they want to continue to do business with, then they’ll allow you to grow more and more.
If you buy them at the same time, that three pack that Bob mentioned, you’re going to generally get a discount if you do it upfront. If you buy one later, you may or may not get that discount.
They don’t have to sell to a partner or a purchaser that is approved by the franchisor. However, most transactions take place between franchisees. That’s one of the advantages of a franchise because you’ve already got a built-in consumer base for your business should you choose to sell it. Many franchisors also have what they call a first right of refusal, so if you get a contract to sell your restaurants or businesses, then the franchisor has the opportunity to step in and pay you that same price.
A business is a business, so yes, you build equity as you build your business, whether that’s your customer base or it’s your physical space, based on what your book of sales is. You’re building equity, but again, a business that’s not a franchise can do the same thing.
It really just depends. It’s going to come down to the owner and how they operate, whether or not they’re being profitable or not and how they run their business.
Going into buying a franchise, you have to pay that upfront franchise fee, and then beyond that, you’re going to pay ongoing royalties. Those can be structured in various ways, whether it’s a monthly percentage of gross sales, whether it’s a flat fee on a monthly basis. When they start, is it two years in? Is it immediately? Those are royalties that you do have to pay, and then there’s also, not with all franchises, but quite a few of them, make you pay into what’s called an ad fund or an advertising fee. That would be a percentage of gross sales generally or a flat fee on a monthly basis. Some will charge a technical fee, depending on what kind of technical aspects there are to the business.
The average royalty is about 6.75, so between 6% and 7.5% is the average. Now, they go higher depending on the kind of service or the kind of franchise that you’re buying into, and it does vary from an advertising standpoint. Whether it’s 1%, 2%, or a flat fee, so it ranges on a franchise-by-franchise basis based on what they’re providing to you.
The only thing I’d add would be, if indeed you operate to the end of your term, because every franchise has an operating license term, five years, 10 years, McDonald’s was 20 years, you can renew that license if you’ve operated properly and the franchisor wants to renew with you. Many times they do have a renewal fee that would be at the end of your timeframe for your operating license.
There’s a fee to buy into the franchise again.
In some cases, it’s discounted. Every franchise operates in a different way.
It can be easier to finance a franchise business and the reason is because your traditional SBA loans, banks are going to require that you have a business plan in place as well as some experience in the industry. If you don’t have experience in the industry, starting your own business, it’s going to be tough. Whereas with a franchise, even if you don’t have experience in the industry, the franchise does, so it can become a an easier path to finance through SBA. Now, there’s other options. There’s options through institutions such as FranFund that offer what’s called a ROBS Program, and those ROBS Programs essentially allow you to rollover your retirement fund, whether that’s a 401(k) or IRA at no penalties, no taxes, and you can use that in order to fund your business.
You can, but that’s not specific to franchises, but it’s a great opportunity.
Bob, Is it easy to get a loan? I understand that from one of our banker friends that they have a list that they look at that says, “These are the acceptable franchises that we will loan for”, and it’s a long list.
The SBA maintains what’s called a Franchise Registry. Banks who are working with the SBA in terms of their guarantee for their loan, for the bank’s loans will look at that registry list and if indeed your franchise is on that list, it’s a lot easier to get the deal done. If it’s not on the list, the bank probably won’t loan you the money.
Obviously, self-funding and whether you get money from family members or an angel investor, but generally in terms of financing for your business it’s going to be some sort of SBA loan or the ROBS Program.
It’s a Franchise Disclosure Document, and it is a requirement of the Federal Trade Commission. Franchises are governed by the FTC. They require 23 items to be communicated by every franchisor to every franchisee. This document is required to be consistent franchisee to franchisee. People who want to negotiate the franchise document run into some problems there, but sometimes you can negotiate territories and things like that, but fees and the rest of the structure of the business is typically governed by that document that is regulated by the Federal Trade Commission.
You essentially would be getting the same deal as everyone short of them having some sort of territory, if the territory is bigger, that maybe that expands upon how much you have to pay, but you’re buying in the FDD from McDonald’s is the FDD from McDonald’s.
I’ve found that to be the case. I used to do a lot of work out of McDill and worked with the veterans looking for businesses as a next career primarily because number one, they appreciate a system, and that’s what you’re buying when you’re buying into a franchise. Secondly, they’re disciplined people. They know how to work hard, and they typically can take advantage of some other financing benefits that are available only to veterans.
It’s all walks of life. Everyone from people coming out of corporate America, so from high level all the way down to anyone who just wants to work hard. It’s all about the passion and getting into business. We see bankers and accountants and firemen and teachers going into business. It’s all about the passion.
You want to have some transferable skills that are going to help you with the business you’re looking at. It’s definitely not just coming in completely without zero experience, it’s how are those transferable skills going to be able to apply to the business?
The franchises that I’ve seen fail primarily fail because, number one, the franchisee failed to follow the system. Number two, a partnership fails and the businesses split apart because of that. Those are the two primary reasons.
Absolutely. That’s what your getting when you get into your franchise. I like to say that when you’re getting into a franchise, you’re buying a business for yourself but not by yourself, so not only do you have the franchisor support, but you also have your fellow franchisees that you can call upon and get a better understanding if you have a problem if they’ve experienced the problem and maybe what their solution was.
It is not something we handle at FranNet. I will refer that out. I will first refer to an attorney who understand franchising. I think that that should be their first call and understanding what their options are there.
At SCORE, we see a lot of entrepreneurs who come to us with their business and think that perhaps that it’s worthy to franchise and they want to expand. I think you should look at franchising as really a growth vehicle, growth alternative for your business, but rules of thumb, you should be in business a couple, three years, something like that. If you’re buying a business, you’d want to look at three years-worth of tax returns. If you’re going to sell a cash flow, you need to verify that for the person that’s going to be purchasing it, that investor is also going to be looking for a return on investment. The rule of thumb is if you can demonstrate a 20% return on investment, then I think maybe you have the financial model that’s worth trying to franchise. You’ve both been very helpful in covering this very complex topic and we thank you for your advice and your expertise. There seems to be many advantages in purchasing a franchise when buying a small business. If I may be of help to you, please contact me at [email protected]
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