Matt Crumpton, Esq.
The Pros and Cons of Franchising Your Business
There is no doubt that the concept of franchising has provided numerous opportunities for people to climb to higher rungs on the socio-economic ladder. Most of the famous brands that exist, especially in hotels and restaurants, are franchise brands. The basic idea of franchising is that there is no reason to recreate the wheel once you find a business model that works. Instead, just take the successful business model and scale it to many more locations.
Of course, it’s not that simple. In this post, we are going to walk through the pros and cons of franchising so that you know what choosing the franchise route looks like for your business.
So, what is franchising? Basically, it is a business relationship between the franchisor, who shares its proven business concept, grants legal licenses, and provides rules, systems and support, and the franchisee, who owns and operates the business and pays royalties to the franchisor based on the sales. The profit that remains after business expenses (including royalties) goes to the franchisee as owner of their independent business.
If you currently own a business, you may be wondering whether franchising your business is the right decision. It’s not an easy choice to make the leap from growing concept to franchisor. Here are the pros and cons to consider so that you can determine if franchising is the right move for your business.
1. You will lose some control of executing the day to day operations of your business. When you franchise, you create a System that must be followed. The System is just the rules in the rule book, usually called the Operating Manual. To use a sports metaphor, the franchisor is in charge of creating the playbook and helping the franchisee create the field of play. The franchisee is like the coach, GM, and team owner combined. The employees of the franchisee are like the players. As franchisor, you are not there in person to ensure that the playbook is being followed at all times. Many business owners feel that their concept cannot be replicated easily. If that is a concern that you have, you should probably avoid franchising – or have very strenuous training to overcome it.
2. You have to learn to deal with problem franchisees. Ideally, you never grant a franchise to anyone who is difficult to work with. In reality, regardless of how in-depth your franchise sales and discovery day process may be, you really have no idea what kind of person a franchisee is before they sign the franchise agreement. In my experience, the 80/20 rule applies here: 80% of the problems come from 20% of the franchisees. But, you are going to have some disgruntled or annoyed franchisees from time to time, if for no other reason, because they are not in control of the System and may disagree about aspects of it. There are strategies to proactively address this tension between franchisor and franchisee – the best among them is to have a profitable concept with strong unit level economics so that everyone wins.
3. You will need to have employees dedicated to helping franchisees. In addition to occasional pushback from franchisees about decisions that you made as franchisor, you will also need to have a plan in place to provide recurring assistance to franchisees. This is much easier to do if franchisees are geographically close. For many businesses, it is a challenge to make the leap to franchisor because the income of the franchisor business may not be enough to pay the franchisor employees that you need to support new franchisees.
4. The legal cost of franchising, especially starting up, is rather high. The biggest financial cost to franchising is legal. This is because franchising is a highly regulated industry. For starters, you’ll have to draft a franchise agreement and corresponding franchise disclosure document. Then, if you are selling franchises in a registration state, you have to be approved by the state. You also have to pay for an audit by a CPA within your first year of franchising (which is around $10,000 per audit on the low end). And every year, you have to draft FDD updates and file renewals with state attorney general offices that require registration. All of that franchising legal work is in addition to negotiating with franchisees, understanding what you can and cannot do with System change, administering the advertising fund, doing deals with vendors, trademarks, etc. You’ll need to have a solid franchise lawyer (preferably with a capped fee rate plan).
5. A mistake by one franchisee hurts the whole brand. Franchisees are locally owned and operated businesses that use a national brand’s trademark under contract. Still, once a brand becomes somewhat well-known, people tend to think that all of the locations have the same ownership. This is a great thing if all the locations are doing a good job following your System. But, one franchisee who has a negative interaction with a customer can go viral on social media and hurt the entire brand. This is another reason why it is so important to monitor your franchisees’ performance.
1. Grow the business using other people’s money. One of the primary reasons for franchising is that it allows the franchisor to grow their brand (and the goodwill associated with the trademarks that they own) without having to finance the expansion. Sure, you don’t get all the profits from the operation. But, you have no liability exposure for the expense and effort of running the business and you get paid royalties.
2. Scale your business faster. Because you don’t have to provide all of the financing and start-up effort yourself, you can scale faster by helping franchisees to scale. If you can find multi-unit franchisees and sign a few, you will scale even faster as individual franchisees begin to open multiple units.
3. Get royalties. The (usually weekly or monthly) royalties that franchisees pay to the franchisor is not passive income. The franchisor has an obligation to provide support to franchisees. You have to operate the infrastructure of the franchise. But, as franchise brands grow, there comes a point in time where the royalty income surpasses the cost of the system. You need to run pro formas for your business to determine what that point is. The bottom line is that you can make serious money owning a franchisor if you can get it to scale.
4. Get rebates. One of the benefits franchisees receive for being part of a franchise is negotiated discounts with vendors to use bulk buying power. This is normally a win-win for the franchisor and franchisee, with the franchisee getting a discounted rate on products they must buy and the franchisor receiving a percentage of purchases as a rebate. However, if franchisees are not getting a discount from current pricing with the deal, they may see the franchisor as acting against franchisee interests.
5. Be in charge of a system. Even though you franchise your business, you still retain control of how the business is run. Some things in your System can be changed at any time, by simply sending out a notice to franchisees. Other changes may only be made at the time of franchise renewal. It depends on the wording of the franchise agreement. But, make no mistake about it, the franchisor is fully in charge of the franchise brand.
Next week, I’ll cover business considerations for running a franchise and tell you what specific things you need to start and successfully operate a franchise business.