October 4, 2023

Small Business Advice

Franchising works, as long you understand the risks

"Nothing is more difficult, and therefore more precious, than to be able to decide." ~ Napoleon Bonaparte

Jerry Osteryoung | 2/13/2015

Franchising is very effective and advantageous for both the franchisor and franchisee. The franchisor benefits from having an owner/manager run a remote business with very little supervision or risk. The franchisee benefits by having the franchisor’s name recognition and proven record of success.

Consider McDonald’s, for example. For the franchisee, name recognition comes the instant the sign goes up. With name recognition comes consistent customer expectations, so the franchisor must be sure that all services and products supplied by the franchisee are as consistent as possible.

With both name recognition and consistency, franchises have a much higher rate of success than non-franchise operations. Because they offer a lower failure rate but higher returns, I highly recommend franchise arrangements to so many prospective entrepreneurs.

Normally, a franchisee pays fees to the franchisor. The initial start-up amount can be anywhere from $50,000 to $700,000, depending on what comes with the franchise and how well received it is. Thereafter, a franchise fee must be paid on all revenue earned over a contract period that ranges from five to 10 years. When the contract expires, there is usually an option to renew.

Franchise fees can range from 3% to 9%. This may seem like a significant portion of revenue to give up except that the franchise provides almost immediate acceptance in the market and a built-in customer base.

Each franchisor is unique in terms of their requirements. With Chick-fil-A, for example, it takes a long time to get approved as a franchisee, and there is a rigorous training and evaluation process. The success rate, however, is amazing.

Franchises typically work out very well, but they can also be a gigantic money pit. A successful plumbing business was doing very well, but they thought they could increase their sales and profitability if they had a franchise.

It only cost the owners $15,000 to establish the franchise, but they had to pay 6% franchise fees on every dollar of revenue earned for six years. It did not matter if the sales came from former customers or new customers -- they had to pay 6% of all services and equipment sold.

Over the contract period, the company paid over $600,000 in franchise fees and received nothing in return. The firm almost went out of business because of this drag.

In hindsight, the person who made the decision to franchise wished he had taken more time to talk to other franchisees and run the numbers so they would have had a better idea of how much the franchise fees would take. He told me afterwards that the decision to franchise was the biggest mistake of his life.

I have shared this horrific story simply to illustrate how franchise arrangements can go wrong. It is a cautionary tale so that you take the proper care when considering starting or purchasing a franchise.

Now go out and make sure you have done the necessary due diligence to ensure your success before you sign on the dotted line for a franchise.

You can do this!

Dr. Osteryoung has directly has assisted over 3,000 firms. He is the Jim Moran Professor of Entrepreneurship (Emeritus) and Professor of Finance (Emeritus) at Florida State University. He was the founding Executive Director of The Jim Moran Institute and served in that position from 1995 through 2008. His newest book co-authored with Tim O'Brien, "If You Have Employees, You Really Need This Book," is a bestseller on Amazon.com. He can be reached by e-mail at jerry.osteryoung@gmail.com.

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