The Franchisee Handbook

Everything You Need to Know About Buying a Franchise

Mark Siebert

• Publisher: Entrepreneur Press
• Year: 2019
• ISBN:
  9781613083994
• Topic: Business
• Subtopic: Franchises
• Index: Business

• 1.7 percent growth forecast for 2016 will bring the total number of U.S. franchises to 795,932. The IFA forecasts employment increases of 3.1 percent to 9.1 million franchise jobs, up from last year's 8.8 million jobs. Plus, total GDP generated by the franchise industry will reach $552 billion, up from $523 billion in 2015, it said. The index has shown growth every year since 2010.
• Step-by-step plan that walks readers through how to research potential franchises for purchase and assess the viability of a franchise opportunity, along with tips on franchisee contract negotiation
• Provides readers with a detailed checklist of must-haves for a successful franchise launch
• Exclusive "Franchise Formula" worksheets and bonus online content
• Extensive resource lists and worksheets

Chapter 1

THE FRANCHISE MYTH

We’ve all heard the stories. How 100 shares of McDonald’s initial stock offering back in 1965 would be worth millions today (more precisely, those shares would be worth close to $12 million as of this writing). How no McDonald’s franchisee has ever failed (although, like all restaurants, even McDonald’s occasionally closes units).

But the stories that really get our hearts pumping are the ones where a friend of a friend became a multimillionaire by buying the right franchise at the right time. Today they own a dozen locations (along with two houses, three cars, a boat, and a plane). And those stories sound all the more intriguing when we hear that the franchisee was just a regular person. Not some rocket scientist who was always destined for success. Not some rich kid who parlayed Daddy’s small fortune into a bigger fortune of their own. Just a person with a dream, a little money, and a lot of courage.

We could have done that, too—if only …

We tend to believe the myth, but what is the reality? What is this magic system, and just how magic is it anyway?

Busting the Franchise Myth

Franchising is, without a doubt, one of the most powerful business expansion strategies in the world today. It has helped some of the world’s most iconic brands expand far faster than they could have ever dreamed of growing organically. But how did it go mainstream? The answer lies in franchising’s fraught beginnings.

Early franchisors, like A&W Restaurants, Howard Johnson’s, Midas, McDonald’s, Century 21, and others, got their start before today’s franchise regulations. Back in those days, franchising was a loosely defined concept, but the early successes of these companies popularized franchising as never before.

By the early 1960s, hundreds of new franchisors were entering the market. Still, franchising was only a small part of the U.S. economy. Unfortunately, along with the legitimate businesses that were getting into franchising, there were some that ended up as well-publicized failures—and in some cases, outright fraud. For example:

In the wake of Kentucky Fried Chicken’s success, John Jay Hooker—a politician with no restaurant experience—created and quickly franchised a concept called Minnie Pearl’s Chicken. When the company began franchising in 1967, it had yet to open its first location. But based on the celebrity endorsement of the country comedian, Hooker sold 300 franchises by early 1968 and went public only months later with just a handful of restaurants open. By 1970, Minnie Pearl’s had opened some 250 locations—and had closed more than half of them! Most of the remaining restaurants were losing money. The SEC later launched an investigation into the company’s accounting practices—eventually forcing the company to liquidate under the pressure of shareholder lawsuits.

Comedian Jerry Lewis also got in on the act when he partnered with Network Cinema Corporation in 1969 to launch Jerry Lewis Cinemas as a franchise. Like Minnie Pearl’s, Jerry Lewis Cinemas featured a high-profile endorser and a business model that did not work. Full-page ads in Variety magazine urged, “Join Jerry Lewis in the most successful money making segment of the entertainment industry.” By the mid-1970s, the chain had as many as 200 locations before the business collapsed under the weight of its failed franchisees.

Not to be outdone, TV host and comedian Johnny Carson partnered with the Swanson family to launch a hamburger and fried chicken franchise called “Here’s Johnny’s” in 1969. Again, hundreds of franchises were sold, most closed quickly, and the company declared bankruptcy ten years later.

Of course, this wasn’t just some evil cabal of comedians. There were many other early franchisors, some with good intentions and some without, that made headlines when their get-rich-quick schemes and high-pressure sales tactics resulted in hundreds of failed franchisees. And while the families who invested in franchises like McDonald’s were living the American Dream, others were living the American nightmare.

It was against this backdrop that, in 1972, the first of the state franchise laws was passed in California. Essentially, the law required franchisors to make presale disclosures to prospective franchisees to allow them to make an “informed decision” on their investment. Other states followed California’s lead, and in 1979, Congress passed FTC Rule 436, commonly called the Franchise Rule. According to this law, which was updated in 2007, prospective franchisees must receive a prescribed disclosure document (called a Franchise Disclosure Document, or FDD) regarding the franchisor and the contents of their contract prior to exercising the franchise agreement. (We will go into much greater detail on the FDD in Chapter 5, but for now, you should know that it is designed to protect potential franchise buyers by giving them the information they need to make an informed decision on the purchase of a franchise.)

In creating this rule, lawmakers had to define just what a “franchise” was, so they could determine whether or not the rule applied to a specific business. In layman’s terms, FTC Rule 436 defines a business as a franchise if it meets all three of the following criteria:

1. It allows the franchisee to use its name or trademark in association with a business.

2. It provides significant operating assistance or exercises significant control over the franchisee (providing operations manuals, training, a protected territory, and many, other things can trigger this provision of the definition).

3. It collects a fee (which can be an upfront franchise fee, a royalty, a product markup beyond the wholesale price, or any of a number of other ways franchisors make money off franchisees).

While some states that have separate regulations governing franchise sales have their own definitions of what constitutes a franchise (and when a franchisor must register their franchise to sell in that state), for our purposes, it is easiest to think of a franchise as a company that offers you the right to operate using their name and business system in return for a fee. While some early franchisors viewed the model as a get-rich-quick scheme, their mistakes helped create laws that protect us today.

No Longer a Punchline

While the early days of franchising saw both visionary entrepreneurs and slick salespeople armed with poor business models, franchising today has evolved into one of the most dominant methods of business expansion and ownership in the U.S.

As more and more businesses adopted franchising as a way to expand, and more franchisees gained experience in their roles, education and best practices specific to franchising began to develop and create the culture of franchising in this country. Federal and state laws were established to better define and regulate franchise relationships. Franchisors learned the importance of systems that were mutually beneficial to the franchisor and their franchisees. In 1960, the International Franchise Association (IFA) was founded to promote franchising. Today, the IFA is a powerful force representing the interests of both franchisors and franchisees.

Many years ago, the U.S. Department of Commerce characterized franchising as “the wave of the future”—and in the U.S., that wave has been landing for the past seven decades. The result of this prolonged trend is the largest franchise economy in the world.

According to the “Franchise Business Economic Outlook for 2018” report prepared by IHS Markit Economics for the IFA Franchise Education and Research Foundation, there are some 759,000 franchise businesses (i.e., individual franchise locations) in the U.S. Altogether, they directly employ more than 8 million people and generate more than $750 billion in economic output. Today’s franchisees are more sophisticated and knowledgeable about franchising than ever before. More of them own multiple locations, and are even franchisees of multiple franchise systems. The advancement and integration of technology within franchising has also contributed a great deal to the success of franchising as a business model. Better technology has facilitated the development of operations training, data accumulation, benchmarking of financial data, and the dissemination of best practices within franchise systems.

That said, it is easy to understand why the growth of franchising isn’t front-page news. After all, the jobs are added a few at a time, as opposed to the Fortune 500 companies that might open a factory employing hundreds or even thousands of people—or lay off 1,000 or more workers at a time. Perhaps the more important question, though, is why franchising continues to record such consistent growth even when the rest of the economy is faltering. To find out, let’s take a quick look at how it works.

How Does It Work?

Franchising has a basic formula. Usually, after selecting the franchise you want to purchase and going through the required presale disclosures (more on that in Chapter 5), you will be asked to sign a lengthy contract (called a franchise agreement) that will limit how you do business. When you sign, you will pay an initial franchise fee, which typically ranges between $25,000 and $50,000, for the right to enter this business relationship (and for the franchisor’s help in the process of starting up your business). Occasionally that initial fee might be nonexistent, while in other instances it can be $150,000 or even higher.

As the franchisee, you will be responsible for all startup costs associated with opening your new business. For a site-specific business, you will probably (although not always) be required to find your own site and negotiate your own lease, according to parameters provided by the franchisor. You will be responsible for the costs of land, building, furniture, fixtures, leasehold improvements, equipment, and the initial working capital required to start the business and get it to and beyond break-even. You will have all the responsibility of hiring, training, supervising, and firing your employees. In a nutshell, you will have full financial and operational responsibility for the franchise business, just as you would with any other business.

Here is where it differs: In addition to paying the upfront fees, you will generally be required to pay a royalty ranging from 4 percent to 8 percent of gross revenue—although I have seen royalties that are nonexistent (wrapped into product sales), and I have seen royalties as high as 15 percent. In a number of franchises, the franchisee will be expected to purchase a specified amount of their initial and ongoing inventory from the franchisor or a designated affiliate company. The nature and amount of these royalties and product markups will vary, as you will see in Chapter 5.

In return, the franchisor will allow you to use its name (although you will have no rights to the name or its associated goodwill). The franchisor will train you on how to run the business, and you must pass the initial training before finalizing the grant of your franchise. Generally, the franchisor will also:

provide you with startup assistance, perhaps including help with site selection and lease negotiation;

work with you and your team at your location during any grand opening;

give you ongoing support in running your business, often in the form of purchasing power, advertising and marketing development, product development, ongoing concept refinement, and field consulting.

Since franchisees are burdened with additional startup costs and ongoing fees, including royalties, it is only fair to ask why this model works as well as it does.

Why Does Franchising Work?

One of the major reasons for the success of franchise systems stems from the nature of franchising itself. As a potential buyer, it is important to understand that franchising is not cutting-edge technology. It is not a strategy to fix a business that is broken. It is a means of expanding a business that is already highly successful.

Franchises succeed where new businesses fail for a number of reasons, the most important of which is that they are using proven business systems to market proven products and/or services. When I do seminars for entrepreneurs around the country, I often ask them to imagine that every store they own burned to the ground. I then ask what would happen if they were to take their insurance money and move to an entirely new city to start all over again. Virtually all the entrepreneurs I meet say without hesitation that they would succeed all over again. If I ask them what would happen if an otherwise sharp businessperson with no knowledge of their business but an equal amount of capital were to try to duplicate their success in a new market, they inevitably feel the newcomer would fail.

I then ask them to estimate how a franchisee of their business would perform, assuming they were adequately capitalized and followed the franchisor’s system to the letter. And almost all of them agree that the hypothetical performance of their franchisees would exceed their own experience when they first started.

Perhaps this is just the hubris of the type of entrepreneurs who are drawn to franchising, but I personally believe it to be true. They have it figured out. They know where the land mines are buried and how to build their business quickly. While I can only rely on anecdotal evidence to back this claim, this tends to be the case in real life as well. And it is that system of operations that you are investing in when you purchase a franchise.

How Franchising Benefits Franchisees

The trust you put into a franchisor is your buy-in. That trust exists because the first element in almost every successful franchise is a proven prototype. Franchisors have made many of the mistakes and subsequent course corrections that will allow you to avoid costly errors during the crucial startup phase. Franchises are systems that have been tested and refined and tested again. And gaining access to that system gives you, as a franchisee, the ability to start faster, reduce your initial investment, and avoid mistakes.

Avoiding mistakes can start before you have even opened your doors for business. As an example, for site-specific businesses, nowhere are these mistakes more impactful than in the area of site selection and lease negotiation. In retail or restaurant operations, assistance with site location and lease negotiation can mean the difference between success and failure. Pick the wrong site or sign a bad lease, and you may have a long-term problem f...