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Is it really a good idea to invest in a franchise?

Wednesday, 23 February 2011 | By Marc Peskett

Franchise businesses are attractive to first-time business owners.

 

In most cases they offer a tried and tested way of doing business that removes a lot of start-up risks.

 

Despite the benefits there are still a number of key issues that you need to consider before signing up.

 

Some of the benefits of buying into a franchise include existing brand awareness and marketing support provided by the franchisor, market knowledge of products or services, established business systems with ongoing support, designated geographic operating territories that manage competition, combined buying power with suppliers and reduced failure rates compared to other small business start-ups.

 

It’s not all upside though. Some of the cons include royalty fees paid to the franchisor reducing profits you can take, less freedom in decision making, higher start-up expenses and a possible bad choice if you haven’t covered all the bases when evaluating whether to buy into the franchise.

 

Comprehensive due diligence is the key to making a sound decision about investing in a franchise business and many of the considerations are financially based.

 

One of the key areas to evaluate is what your investment costs will be – franchise fees for the initial purchase can be as low as $10,000 or as high as $1m.

 

The franchise fee normally covers licensing costs to use the franchise name, rights to use the systems, as well as the cost of training, support and site selection. Specific software requirements may also be built into the franchise fee.

 

Additional costs might include fit-out (equipment, furniture, fittings and signage), inventory (products you need to stock) and other supplies involved in running the business (office supplies for service-based businesses or cups and utensils if you’re in the food service sector, for example).

 

You also need to factor in costs for legal and accounting advice, staff recruitment, insurances, Workcover and any finance lending you require.

 

In addition to the franchise fee you will typically pay ongoing service fees or royalties to the franchisor and possibly a franchise renewal fee.

 

You may also require working capital to ensure that you have sufficient cash to meet the day-to-day needs of the business and finance the gap between when you outlay operating costs and recover those costs when your customers pay you.

 

When all those costs are taken into consideration the three most important questions you need to address are:

  1. Can you afford to invest?
  2. Is the franchise well run?
  3. Will you get the return you expect?

It’s important to be clear that you’ll have the funds required before you spend too much time and energy negotiating with the franchisor or heading down the path of choosing a site and starting training.


Training could be a substantial investment because some franchise training programs run for six months full-time, when you won’t be earning an income.

 

It could all be a waste of time if it turns out that your bank is unwilling to provide any loans you may require.

 

Banks will request information and reports from you or the franchisor in order to assess your lending needs.

Understanding the bank’s criteria and providing the right information helps smooth the path to obtaining the approvals you need. Some franchisors have bank accreditations in place to assist in that process.

 

The second key area to look at is the quality of the franchisor and the franchise system. Some areas to assess are:

 

  • How long the franchisor has been in business.
  • What the franchisor’s strategy and plans for growth are.
  • Is it soundly financed? You may need the assistance of an accountant to review audited financial records.
  • What qualifications and experience the directors and managers have.
  • What innovations the franchisor has introduced.
  • How ongoing support and training is provided.
  • Experiences that current and former franchisees have had with the franchisor.

 

Prospective franchisees should be able to obtain sufficient information from the franchisor to be able to make an informed decision about entering into a franchise agreement.

 

All franchisors need to comply with the Franchise Code of Conduct, which covers the key areas of disclosure, franchisee rights under a franchise agreement and dispute resolution.

 

It applies to all franchise agreements entered into or extended on or after October 1, 1998 and is enforced by the ACCC, which is responsible for investigating complaints and providing education in the form of guides, articles and presentations.

 

If after working through those issues you’re still keen to invest in the franchise you’ll be asking them to “Show me the money!”

 

Franchisors can provide projections of your earnings potential but they can be misleading. Some key questions to ask when reviewing projections are:

 

  • Is the projection based on average incomes?
  • Are all franchisees included in the projection, including underperforming ones?
  • Are a small number of high performing franchisees inflating the figure?
  • If not all franchisees are included what is the geographic spread and impact of any cost and market conditions that vary by location?
  • Are any of the franchises company-owned? Company owned sites may have different or discounted costs.
  • Are figures based on gross sales that don’t show actual costs or profits?
  • When will you break even, receive income and a return on your investment?

Finally at some point in time you’ll sell or exit the franchise, making it important to also understand the conditions for ending the franchisee agreement and what intellectual property or other rights you will own.

 

Covering all your bases and obtaining an accurate picture of what you’re investing in will assist with making the right decision and reaping the rewards that come with it.

 

Marc Peskett is a partner in MPR Group, a Melbourne based firm that provides business advisory services as well as tax, outsourced accounting, grants support, financial planning and finance lending services to franchise businesses and fast-growing small to medium enterprises.

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