Subscribe to Entrepreneur for $5

Early Birds...

Opinions expressed by Entrepreneur contributors are their own.

Thinking of investing in a fledgling franchise? First weigh the risks and the rewards.

At a time when every economist, every media chart, every consultant, every scared corporate pawn seems to be urging caution, caution, caution, a select group of renegades insist on pushing the entrepreneurial envelope. Their transgression? Buying a new franchise.

By all accounts, it's a risky move. "It takes a certain type of personality to get into this," says Bob McDonell, who became the first franchisee of CDX Audio Development Inc. to open a CD Exchange, a retail store selling used compact discs. "You have to enjoy trying to beat the odds. Some people say I'm crazy. But I'm just a risk taker who enjoys tackling challenges."

In a system dominated by McDonald's wanna-bes, why would someone willingly become the guinea pig of a no-name franchise operation? The call of potential greatness ("You could be the first franchisee of the next McDonald's") is, for some, as strong as the beckoning of sirens. For others, the idea of working with a franchisor to build a system from the ground up is exciting. With a new franchise company, says McDonell, "you don't get lost in the shuffle. You can have a tremendous amount of input, and there's a lot more ground to break."

Yet, no matter how alluring the promises, as a prospective franchisee, you should never "surrender to the salesman's serenade," warns Gerald A. Marks, a franchise attorney in Red Bank, New Jersey, and author of The Buyer's Guide to (FranAnalysis Press). "You must investigate, especially in a new franchise, to determine whether this is just the franchise du jour."

The "luster" of franchising's early days is still bright enough to spark a glint in many a would-be franchisee's eye, says Washington, DC, franchise attorney Andrew Caffey. "Franchising [has produced] some extraordinary success stories," he says. "Also, some people aren't attracted to the idea of being one more franchise owner among hundreds. They want to be pioneers, and to be in a position to reap the benefits of that risky investment."

Though the idea of risk may occasionally stir visions of Indiana Jones-type thrills, no one can ignore the real-world dangers of buying a new franchise. "Even if you get in on the ground floor," warns Caffey, "the elevator may still go down to the parking garage."

The general public equates franchising with a few big names; in reality, most franchise companies are small. About 70 percent of all franchisors have fewer than 50 locations, according to Francorp Inc., a management consulting firm specializing in franchising. Francorp executive vice president Michael Baum says about 200 to 300 new franchise companies enter the market each year.

But, of course, not all those are hits. Dean Sager, an economist with the House Committee on , emphasizes that though "there may be some out there, a large percentage of [new franchises] won't be around in two years. You don't know which is going to be the next strong operation--the next Ben & Jerry's--and which is going to be the next [quickly forgotten] name."

Pros And Cons

Despite the warnings of naysayers and the horror stories of former franchisees, people continue to seek new franchises for a variety of reasons. First, new franchises sometimes offer a freshness that entrepreneurial types are drawn to. "Very good, novel retail concepts are created all the time," says Caffey, "and an investor may just know in his or her bones that this type of business would work."

Many franchisees find not only the concepts, but the locations of the franchise companies refreshing as well. "We're detecting a real upsurge of new business ideas in smaller towns," says Baum. "You don't need to have a lot of industry to come up with a good franchise idea."

McDonell cites another advantage: support. "I can call the [franchisor] anytime, and they'll recognize my voice," he says. "If down the road there are 5,000 CD Exchange stores, the person who signs up for the 5,001st isn't going to have the same relationship with the organization that I do. That's a real advantage."

Like McDonell, many entrepreneurs prefer this type of interdependent relationship over the established support systems of large franchisors. "There are fewer people to depend on [in a new franchise company]," says Baum, "but they will also have fewer people to support. And the new franchisor knows the success of these franchisees is critical."

In a new franchise system, your location also determines the level of support you'll receive. Because you're forfeiting the national name recognition of a KFC or Burger King, you should try to locate your business as close as possible to the franchisor's headquarters. Obviously, you want to capitalize on any overlap in local reputation. And, logistically, you need to be near the franchisor just to stay in touch.

"[A new] franchisor just doesn't have the money to go back and forth to help you," says Marks. "It's a cardinal rule [for franchisees] to locate close to the franchisor to get the maximum benefit of their support."

Another significant opportunity for new franchisees is the ability to negotiate initial fees. "Investors in new franchise programs have more power than they think," says Caffey. "Franchisors want to get the right franchisees, and they will often negotiate very favorable terms on the initial fee. That fact is not going to be disclosed in the offering circular. But an investor really shouldn't be asked to pay full price when the program isn't proven, and the investor is part of the grand experiment."

For maximum risk protection, you could go the extra step and negotiate for deferred fees as well. "This may be more difficult to accomplish," says Caffey, "and requires some pushing on your part."

Rather than plunking down a lump sum while stifling your concerns about the franchisor's ability to follow through, propose to the franchisor that the initial fee be paid over a period of time. For example, if you need to pay a $30,000 fee, you could protect yourself by offering to pay $5,000 upfront, another $10,000 after initial training, $10,000 at the completion of the site selection process, and the balance at the end of your first month in operation.

"If anywhere along the way there is a serious disappointment, or you discover something you didn't understand when you first signed the contract, at least you'll still have some money in your pocket," says Caffey. "And you'll be in a position of considerably greater strength."

By The Numbers

The key to striking a balance between cold, hard realism and the frivolity of betting on a long shot is setting goals that are practical and intelligent. "I hope CD Exchange [becomes huge]," McDonell admits. "But I also knew what I wanted to accomplish, and I can do that whether CD Exchange has five franchisees or 500. What was more important to me was that the business made tremendous sense, that it was something I could grow and develop and have fun with."

Though McDonell relies on his franchisor for insight and support, he also accepts responsibility for his own success or failure. "A franchisee has to do a good job investigating on the front end," he says. "You can't just get a prospectus, lay out the cash, and expect to be off and running. You have to find out what the [franchisor has] to back [its claims], whether it's able to deliver, and what kind of support you can expect. You can't go into any business expecting a quick buck. You have to realize you're in this for the long term."

Having realistic goals and investigative instincts is a good start; still, many franchise relationships end bitterly if the franchisor has a bad attitude. Keep your eyes open, and you may be able to separate the good from the bad.

"Many people can tell when they're getting the hard sell," says Sager. "It's the difference between a franchisor saying, `We agree these things have to be in place, and we will work with you to analyze it before we take your money,' and saying, `Just give us the money, and we'll work something out later.' The ultimate question is, Are they concerned with building a franchise system very carefully, or are they just interested in selling franchises?"

Unfortunately, bad franchises aren't always easy to identify. "It's important for an investor in a new franchise to take the Uniform Franchise Offering Circular [UFOC] apart," says Caffey. "Read every aspect of it. These documents are often written with a subtlety that's lost if you're just flipping through the pages. A new franchisor often makes projections, guesses and estimates for the costs involved. Take the document containing the franchise agreement to a competent lawyer who can give you a sense of what this relationship is going to be like and what legal obligations are going to be imposed."

Some UFOC items to take a good, hard look at before you sign include:

1. Financial statements. "Often, established companies beginning a franchise program will create a new corporation that serves as the franchisor," says Caffey. "Know exactly whom you're dealing with." And, because undercapitalization is always a danger when dealing with start-up franchise companies, check the UFOC for the company's net worth.

2. Trademarks. "A new franchise program often doesn't register its trademarks federally," Caffey says. "If it hasn't, franchisees may later be deprived of using the name after investing in signs, stationery, business cards and the like."

Item 13 of the UFOC, pertaining to trademarks, should disclose the serial number the company received at the beginning of the registration period. If that number is missing, and you find the franchisor hasn't registered with the proper authorities, ask what steps have been taken to do so. A promise that they "intend" to register the mark federally should raise a red flag.

3. Background of the principal officers. Do they have industry experience, or are they fast-food whizzes starting a decorating franchise? Do they have a background in franchising? "A lot of companies don't understand franchising very well," says Caffey. "They assume they can relate to franchisees the way they have with employees or dealers, and don't understand the special handling that's the hallmark of a good franchise program."

The officers' background is revealed in Item 2 of the UFOC. Still, reading the document is no substitute for going to the company's headquarters to meet the franchisors. "You have to be comfortable with the people," says Baum. "This is a matter partly of getting their credentials and partly of pure instinct."

McDonell spent six months with his franchisor, observing operations in the four company-owned stores, before opening his first location in May 1992. "[The franchisor] knew this business. He grew it," says McDonell. "I was talking to somebody who knew what was going on out there, who had experienced the pitfalls and the triumphs."

4. Existing franchisees. One of the most important and insightful research aspects of the franchise selection process is talking to existing franchisees. With a new franchise, however, there may not be any. "This is one of the most difficult aspects for both sides of the program," says Caffey. "How does the franchisor sell to the investor, and how does the investor evaluate the [business's] experience and success level, if there are no other franchisees to talk to?"

Considering the gravity of this step, you should inquire, even if the franchisor states in Item 20 of the UFOC that they have no franchisees in operation. "There may well be franchise investors who opened units since the document was written," Caffey says. "Seek these people out and ask what their start-up experience has been, whether they spent more money than the franchisor estimated, how many hours they put into the business, and how they feel about their investment."

Don't limit your detective work to the UFOC, either. Other informational avenues to tap include:

* Operations manual. This book often illustrates the difference between franchisors' promises and reality. Though you may not be able to remove it from the company's premises, you should "hold it in your hands, flip through it, and look at the headings," says Caffey. "You need some assurance that the document exists, because all too often it doesn't." If a franchisor turns on the razzle-dazzle, saying the manual is confidential and can't be revealed until you show up for training, that's probably as good a time as any to walk away.

* State attorney general's office and the Better Business Bureau. Ask for any complaints on file or recent actions against the company. If you're in a state that requires franchise registration, call the state officials that administer those laws to find out whether the franchise is registered. If it's not, there's no need for immediate panic--registration may be pending. However, Caffey notes that a well-advised franchisor will cease any further offering activity until the registration process is complete.

* materials. "This is an important form of communication between a franchisor and prospective franchisees," says Baum. "It really doesn't bode well if [the franchisor] shows you a bunch of loose papers thrown together in a folder."

* Product pricing data. "A lot of franchisees have found big problems lurking in product pricing," says Caffey. "Once they've committed to buying a line of products, they may find it's been marked up way above market value. Franchisees may end up squeezed between the high cost of inventory and having to pay a franchisor a royalty of gross receipts."

If you're buying a franchise that requires you to rely on the franchisor or a designated supplier for a specialized product, find out exactly what the costs are and how that will affect your business' success.

Risky Business

When McDonell bought his first CD Exchange franchise, the only things guarding him from living a franchisee nightmare were his instincts, his business planning skills and sufficient start-up capital. Today, he owns five stores in Iowa, earning total sales in excess of $1 million in 1993.

"With anything you do, there's a risk, and I was willing to take it," McDonell says. "When people found out I was going to do this, they told me I was nuts. I was the vice president of a fairly good-sized company, and people thought I was crazy to throw that away."

Yet McDonell believes risk is in the eye of the beholder. "There are no guarantees. You could go to work for a major corporation that goes belly-up," he says. "In a lot of ways, being a franchisee [of a new franchise] gives you more control over that risk, over your own future."

Ones To Watch

New franchises often drop conspicuous crumbs leading the way to trends in the franchising world. According to Francorp's Michael Baum, notable new franchising trends include:

* Businesses that didn't exist a few years ago. These include used-CD stores, single-price discount stores, and unique approaches to providing mortgage loans through retail.

* Homebased franchises. Baum believes this trend will continue as more people realize professional businesses can be run from home.

* Franchises inspired by the success of previous franchise concepts. For example, the popularity of children's recreation franchises like Discovery Zone has resulted in a new niche.

* Back-to-basics franchises. In the food business, for instance, people are eating up a concept so old, it's new. Home-cooked food is back . . . with '90s marketing power.--J.H.

Contact Sources

Andrew Caffey, 555 13th St. N.W., #1238E, Washington, DC 20004-1109, (202) 637-6857

CD Exchange, 124 Collins Rd. N.E., Ste. B, Cedar Rapids, IA 52402, (319) 373-9604

CDX Audio Development Inc., 2830 Ramada Wy., #200, Green Bay, WI 54304, (414) 592-9660

Francorp Inc., 20200 Governors Dr., Olympia Fields, IL 60461, (800) 877-1103, (708) 481-2900.

Entrepreneur Editors' Picks