Franchise Buying Guide

Will I Make Money As a Franchisee?

Presented by Guidant Financial
Guidant Financial specializes in helping entrepreneurs purchase new franchises using their retirement funds.

OK, so you think you're ready to buy a franchise. You've done some research. You've weighed the pros and cons. You've selected a business with an interesting product. You even know what you'll wear to work and how many hours you expect to be there. Yet in spite of how much preparation you've done, you still don't know the answer to the most pressing question: Will your business make money? No franchise company--no matter how glorious its track record--can guarantee financial success. But you have a much better chance of having a winning proposition if you follow these practical pointers before you sign on the dotted line.

1. Know thyself.
Choose a business in which you really believe you can excel--a business that matches your singular set of skills and interests as closely as possible. Assess your strengths, weaknesses and blind spots. Visit existing units of the franchises you've targeted and talk to the franchisees. Are they like you? Are they more driven or far more laid-back? Volunteer to work in a franchise for a few days, then decide if you're truly passionate enough to own one. As Houston franchise attorney Richard Solomon puts it: "If you just like soup, buy a bowl of soup. Don't buy a franchise that serves it."

2. Avoid fads.
Is the sector you've chosen hot or just overheated? You won't make money if the business is in a sector that's about to implode. Avoid franchises built around unique products or services that have attracted too many copycats, counsels Timothy Howes, principal of Spyglass Strategies, a franchise consulting firm in Dartmouth, Mass. "Past fads," he says, "included auction drop-off sites, ink cartridge refill stores and dinner-preparation retailers. Where are they now?"

3. Be wary of sales.
Franchises that have many existing units for sale could be troubled. Check websites that list franchises for sale, like Sunbelt, a business brokerage, to see whether current franchisees are trying to unload their gyms, clothing stores or sandwich shops at bargain prices.

4. Use a scam filter.
While you're on the Internet, type into the Google search bar the name of the franchise you like, followed by the word "scam." This may lead you to complaint sites where current or former franchisees rant about their experiences with the franchise company. Don't be too concerned if there are just a couple of general complaints. Every franchise system has a few disgruntled players. But if you find a pattern of complaints, it's probably best to drop that franchise and move on.

5. Be cautious of startups.
Joining a new franchise can be risky, and in the current economy, many newcomers will disappear before they gain traction. According to FRAN-data, a franchise research and consulting firm in Arlington, Va., 604 new franchise systems have started since 2006. Principal Sue Bennett of FranFinders, a franchise consultancy firm in Duluth, Ga., advises her clients to look only at systems that have been in business for five or more years and have at least 25 open franchise units. The exception, says FRANdata president Darrell Johnson, is a new company started by franchise veterans who have had success with other brands.

6. Happiness counts.
Two companies, Franchise Business Review in Portsmouth, N.H., and Franchise Research Institute/FranSurvey in Lincoln, Neb., survey the franchisees of many systems to determine their levels of satisfaction. You can find lists of those with the happiest franchisees on the websites of Franchise Business Review and FranSurvey. Generally, franchisees are content if they're making money. But money isn't everything. "There's a lot of gray area," says Franchise Business Review president Eric Stites. "A franchisee could be meeting your expectations and you're happy making $75,000 a year. Or somebody making twice that could be unhappy."

7. Research.
Then research again. A franchise may pass all the above tests and still be in trouble if its underlying industry is about to change (think video rental stores). Research the industry you plan to join by reading business publications as well as the print and online trade press. Is a national fast-food company about to come out with a cheaper version of the very product your chosen franchise sells? Will Medicare soon stop funding the service you hope to provide? Due diligence can make all the difference.

8. Study the Franchise Disclosure Document.
Franchise salespeople used to send FDDs--many are several hundred pages long--to the homes of prospective franchisees. Now they just send you a link, and you can download the document onto your computer. Here are a few tips:

  • Scroll to Item 3 in the FDD, Litigation. Most franchises have a pending lawsuit or two. But if you find a slew of franchisee lawsuits based on language like "breach of contract" or "unfair encroachment," count yourself lucky that you didn't sign with that company.
  • Turn to Item 20, the List of Franchise Outlets, and do some simple math. How many units have closed in each of the past three years? All franchisors were hit with closures during the recession. But if 5 percent or more of the franchises have shut down in a single year, it may be a red flag. If closures are minimal, print out this section, because you'll need it later.
  • If the FDD has an Item 19, Financial Performance Representations, print it out, too. Franchisors are encouraged to include statistics about how much current franchisees are earning, but only about 35 percent of them do. New franchise systems simply don't have enough data; some older systems have the data but prefer not to share it, and franchise consultants wonder if that's because their numbers are not as rosy as their promotional materials suggest.
  • Remember, the existence of an Item 19 does not mean you'll immediately see how much money you can make with a franchise. For starters, the majority of FDDs reveal total sales of franchises open for certain amounts of time--one year, three years, etc.--and not their profitability. These numbers may look impressive, until you start subtracting the cost of labor, rent, supplies and the like. And remember that the franchisor's royalty and ad fees are calculated on those gross sales, whether the franchise is profitable or not.
  • Make sure the Item 19 numbers are based on franchised units, not corporate stores that don't pay royalties, Stites adds. And check whether the totals in each category are means or averages. "Especially in a smaller system, averages can be skewed by a handful of high-performing units," he says.
  • A good FDD breaks down average franchise unit sales per year, then subtracts average expenses, such as the cost of goods sold, labor, rent and other facility expenses, the cost of equipment as well as general and administrative expenses to get to EBITDA (earnings before interest, taxes, depreciation and amortization). What's left is the total owner benefit. Numbers may be further broken down according to the system's top-, middle- and low-performing franchisees and/or by the number of years franchisees have been in business.
  • If that owner benefit looks enticing, does it mean you'll be making similar money if you open the same franchise in your community? Perhaps. But you or your accountant must run other numbers first. Scroll to Items 5 and 6, which spell out the total fees to join the franchise, including royalties and monthly assessments for technology, back office support and other charges.

    Next, Item 7, Estimated Initial Investment, is crucial. Print it out and match the franchisor's suggested numbers with what is available in your area. This works best if you compare Item 7s from one or two other franchises in the same sector at the same time. Are commercial rents in your town higher or lower than the franchisors suggest? What about the going rate for hourly workers? If you're borrowing money to open the franchise, make sure you add in your monthly payments and interest costs. Once you subtract all the expenses you added up from Items 5, 6 and 7 from average total sales, that owner's benefit may look more attractive or less so. Or you may discover that one of the competing franchises could be less expensive to run, and therefore more profitable, in your community.

    Dale Jacobs, a franchisee with Aaron's Sales & Leasing, an Atlanta-based franchise that leases computers, furniture TVs and appliances to people with poor or no credit, says that studying Aaron's detailed Item 19 helped him decide to open his first store in rural Kentucky in 2007. "I could see that for the first 24 months, you're spending more on inventory than you're taking in. But once that turns, you start to see a ramp-up in earnings," he says. Jacobs has since opened four more Aaron's and signed on for a total of 13 in Kentucky, Tennessee and Virginia.
     
  • If the FDD has no Item 19, you can make a rough estimate of total sales by turning to Item 21, Financial Statements, and dividing annual royalty income by annual franchise sales. If you then divide that number by the number of franchises open for the full year, you'll get an idea of gross sales per franchised unit. Or you can just ask current franchisees what they're making.

9. Meet the people.
It's smart to visit (or at least call) franchisees who already operate the concept. Obviously, you can't begin by asking their income, but if you've studied the FDD, you can say something like, "According to the franchisor's Item 19, a unit that's been open for three years should have [this amount] in total sales. Has that been your experience? Were your expenses higher or lower than those spelled out in the FDD?"

Franchise Research Institute/FranSurvey CEO Jeff Johnson suggests beginning every conversation by stressing that you will keep their answers and opinions confidential. "If franchisees fear you'll be reporting their comments back to the franchisor, they'll never tell you if there's a problem," he says.

Jim and Vera Duchak called 14 franchisees before opening a Right at Home franchise in Zelienople, Penn. "We started out investigating two different senior-care franchise systems," says Jim Duchak, "but were leaning toward Right at Home because it was a more mature company. We asked our accountant and attorney to review their FDD, and they agreed that it was very thorough."

The Duchaks then grouped franchisees by how long they'd been in the business, "and we had conversations with those people," he says. "We checked the Item 19 numbers with them, but we didn't leave it at that. My phone calls always ended with, 'Are you satisfied financially? Was this a good decision?' When the people who had been open for three years or more all said they felt they were providing a good service at a fair price, we decided to go ahead." The couple opened their franchise in September 2010 and feel they are on track to do as well as other owners.

So, will your franchise be profitable? No one knows for sure. But if you choose one that fits who you are, avoid those where there are obvious warning signs and, of course, conduct a thorough investigation, you will help put the odds in your favor.

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Julie Bennett is a freelance writer.

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This article was originally published in the January 2011 print edition of Entrepreneur with the headline: But Will I Make Money?.

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