Doing the Math

In our last issue, Jack and Diane thought they had found the perfect location for their business. But the search doesn't stop there.

You learn a lot when you start shopping for commercial real estate. For Jack and Diane, the first lesson they learned was how expensive the perfect parcel can be. But when the visibility, access, customer demographics, zoning, competitive placement, sign restrictions and daily car counts of a given site are just right, the owner generally becomes pretty proud of his little slice of the world.

Be aware that, even when you've found the perfect location for your franchise, a brand new round of issues will surface. One of the new franchisee's biggest decisions is whether to purchase or to lease the land and building. If you must have a location in a shopping mall, this isn't much of an issue. You'll soon learn, however, that a small tenant is very much at the mercy of the lessor. After all, they don't call them landlords for nothing.

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If you don't buy the land, you save on the initial cash outlay. However, when your franchise agreement expires, you won't have any remaining salable assets. After all, a franchise is really just a license that permits you to generate cash flow.

To make the best decision, you should be in constant contact with your banker, because rates and the amounts loaned on a project vary if you have land to use as collateral. In Jack and Diane's case, they have plans to open three oil-change centers, so conserving cash on their first unit is paramount.

The Not-So-Clear Cost of Getting Started
Heeding Mark Twain's warning, "Lack of money is the root of all evil," you should always take franchise start-up costs into account when it comes to deciding what kind of location you're able to afford. Running out of money is never a happy situation.

So how exactly do you determine those start-up costs? The franchisor estimates start-up costs in Item 7 of the Uniform Franchise Offering Circular, and the quality of these disclosures reveals how forthright the franchisor is regarding the franchise opportunity. Item 7 requires the franchisor to use his or her experience in determining the low and high range of costs in a variety of categories.

For Jack and Diane's oil-change franchise, I believe the working capital that's required is inadequately stated. In this case, the franchisor did not provide a range for working capital; the footnote indicates the estimated amount of working capital required could vary anywhere between two to six months and also depends on whether you hire six to 12 employees.

In my opinion, the single estimated amount of $30,000 does not address these variables. In addition, I'm pretty certain that 12 employees cost twice as much as six, and six months is three times longer than two. So when the franchisor tosses out a single number, you'll have to forgive me for being incredulous.

Fortunately, Jack and Diane claim they're prepared to weather negative cash flow for up to a year, but such a harrowing experience would be comparable to a journey through hell. A situation like Jack and Diane's could have a potentially devastating impact on someone who decides to enter a franchise opportunity and doesn't have a sufficient nest egg in his or her back pocket.

Paying Through the Nose?
Considering the fact that success is subjective and that there is no real franchise law governing its definition, it's best to put your optimism aside and become extremely critical when you're investigating a potential franchise site. Your primary aim should be to find the cream of the crop and analyze their approach.

Interviewing existing franchisees who are the best performers helps you isolate the factors contributing to their success. For example, if all the top performers spent the extra money for a drive-thru window, you should find a location that allows for a drive-thru window, too. If all the successful operators are in small towns, then you may want to think twice about opening your business in a large city.

You'll also want to look at what types of stores the franchisor has continued to operate. In Jack's case, he had the option of purchasing a franchise for a single-bay oil-change center, or a multibay center for an initial fee that's $10,000 higher.

Because he thought a single-bay business could create a choke point in his sales, Jack decided to investigate and found no one in the system had opted for the smaller operation. And yet the franchisor still offers this option--no doubt to attract franchise buyers who have less available capital.

Sometimes, however, you'll find that the less expensive version of the franchise deal does turn out to be the better option. For example, if a pizza delivery operation has the same sales potential as a free-standing restaurant with the same brand name, your profits will be higher with the operation that has the smaller footprint and lower fixed costs.

Unfortunately, there's no rule of thumb for these unique site-finding decisions other than making sure you always optimize your business's chances for success. According to Jack, "First, you'll have to do your homework, and then you'll have to make your best educated guess."

Tune In Next Time . . .
Next month we'll learn whether Jack and Diane find a developer to create a build-to-suit lease opportunity. Will the franchisor approve the site selection? Will the building fit on the lot? Does Jack get an easement from the adjacent gas station?

Todd D. Maddocks is a franchise attorney and founder of Franchisedecision.com. Write him at yourcounsel@attbi.com.