The Real Cost of Franchising Your Business
Franchising can be a 'low-cost' way to expand your biz, but it's not 'no cost!' Here are the pros and cons.
One of the greatest advantages of franchising is that it allows business owners to expand their business using "Other People's Money." Franchisees typically pay for all the startup costs for each new unit. Real estate, build-out, inventory and the negative cash flow of starting a franchise are all borne by the franchisee. What's more, the franchisee typically pays the franchisor an initial franchise fee that helps defray the franchisor's cost of providing any initial assistance (such as training, site selection assistance, initial support, etc.).
This system is extremely powerful, as it essentially frees the franchisor from capital constraints--and allows the franchisor to open franchises virtually "as fast as they can sell them." But that last sentiment, while true in some respects, can be a very dangerous sentiment if taken too literally.
While franchising is a "low cost" means of expansion, it is not a "no cost" means of expansion. And, as with most new businesses, one of the most significant causes of failure for new franchisors is undercapitalization.
One of the most important things to remember when making the decision to franchise is that you are creating a new business--not simply an extension of your existing business. Regardless of the business you started in, you need to understand that franchising is the business of selling and servicing franchisees. And your first and most important priority must be to make your franchisees successful.
While this new business allows you the ability to grow very quickly in a highly leveraged way, you still need money to make money. So how much is enough?
The 31 Flavors of Franchising
Over the years, we have heard consultants and pundits float all kinds of estimates for the costs involved in franchising your business. Unfortunately, these estimates can vary considerably. This is due, at least in part, to the fact that franchising can be done in a number of different ways. The bottom line: The most important factor you should take into account when estimating the costs of franchising is the aggressiveness of the desired expansion program.
Say, for example, you want to open one or two more units in your local market by franchising. Perhaps you're looking to provide an opportunity to your relatives or existing employees. Perhaps you only have modest expansion goals.
In this scenario, you, as a prospective franchisor, need only to figure out two basic costs: legal and quality control.
Legal Costs. You should retain an attorney who is a franchise specialist, as this area of the law is highly regulated and complex. From a legal standpoint, an inexpensive attorney specializing in franchising might develop your basic legal documents (franchise agreement and Uniform Franchise Offering Circular) and other related work (trademark protection, license agreements, etc.), for as little as $25,000. Depending on the state where you offer and open franchises, you may also need to comply with state registration laws that could cost several thousand dollars more.
You'll probably want to create a new corporation and need to have a CPA conduct an opening audit of that company's balance sheet (up to three years of historical audits are required if the existing company will be the franchisor, but most new franchisors opt for the creation of a separate franchise entity for a variety of reasons). And while certain states look askance at a weakly capitalized franchisor, in nonregistration states, there are no laws or guidelines governing initial capitalization, so a couple thousand dollars might cover the creation of this new entity.
Quality Control. Despite a desire for conservative growth, you still want to control quality--after all, you've built your name and reputation over the years with painstaking care, and you won't want to take a chance on hurting your existing business by allowing the brand to suffer. Thus, you need to create an operations manual that will be the governing document controlling quality within the system. Without this operations manual, you run significant risks relative to brand maintenance, as the operations manual defines the standards of quality required of the franchisee, and is incorporated directly into the legal contract between franchisor and franchisee.
While some entrepreneurs choose to develop their own operations manuals internally, this path carries certain risks. The operations manual, if properly crafted, not only controls quality, but also limits the franchisor's liability relative to the acts of the franchisee and the franchisee's employees. To do that, the operations manual needs to cover not only day-to-day operations, but a wide array of topics, in a way that does not create incremental liability through negligence or inadvertently creating an agency relationship. But even if you were to create a professionally developed operations manual using a company such as mine, the costs of developing this manual would likely run under $25,000.
So to sell a few franchises locally, the documents needed to get started could be developed for about $50,000. But what if you have more aggressive growth plans?
How High is "Up"?
If you're seeking to franchise aggressively, however, these costs can increase significantly.
Legal Costs. Legal expenses for a more aggressive rollout may include additional state registrations and more aggressive and/or complex development contracts (area development contracts, area representative contracts, etc.). There are 14 registration states and a number of business opportunities states--each has franchise registration fees aggregating somewhere north of $6,000, not including the incremental legal costs your franchise attorney charges you. All told, the legal costs for this more aggressive franchise program can reach $50,000 or more.
Planning Costs and Consideration. A more aggressive growth strategy, by its very nature, also requires additional planning. While a company planning on conservative growth can probably get away with a fairly informal planning process, aggressive growth dictates a thorough understanding of the competitive environment and the financial implications of each business decision. You need to build these financial and structural decisions on a solid understanding of the organization, and know the costs of building that organization in terms of people and capital.
The aggressive franchisor must bear in mind that even seemingly small mistakes, when multiplied by hundreds of franchisees, can be the difference between success and failure. Take royalties, for example--while the difference between a 4 and 5 percent royalty may seem small, that additional 1 percent could cost the franchisor $5,000 to $10,000 or more per franchise sold. That "1 percent mistake," when multiplied by 100 or more franchisees and by five or more years on the contract, can easily mount into the millions.
Unfortunately, this more thorough planning process can be quite expensive. Depending on the nature and scope of research conducted on the market and on competitors, the amount and complexity of financial planning, and various other factors, the costs of hiring a consultant to assist in the development of these plans could range between $25,000 and $35,000. In more complex situations, this planning can become significantly more expensive.
Quality Control. With more aggressive expansion plans, quality control will also become both more cumbersome and more expensive. With more franchisees going through the system, there will be a need for a more formalized training program, and perhaps training videotapes and other training tools. Again, this could double the costs of your quality control.
Marketing Your New Franchise
Of course, the biggest difference between the conservative and the aggressive growth franchisor is in the areas of franchise sales and marketing. While the conservative franchisor will be content to let prospective franchisees come to him and operate in a reactive fashion, the aggressive franchisor will want to "make it happen."
Brochures. Your marketing efforts start with the development of professionally designed materials. A full-sized, four-color brochure is virtually the cost of entry in modern franchising. This brochure not only sells the franchise opportunity to the prospective franchisee--it also plays a key role in demonstrating the credibility of the franchise to key influencers: accountants, attorneys, bankers and spouses, who will play a key role in the franchise selection process. The design of a good brochure will cost between $7,000 and $10,000. Printing this brochure, depending on print process, paper quality, quantity printed, and a variety of design specifications (full bleeds on pages, dye cuts, stapling, etc.), will cost another $8,000 to $10,000.
For companies with physical units, or companies that plan on using a lot of direct mail or trade shows to promote their franchise, another great tool is the mini-brochure. This brochure, typically done in a two- or three-fold format, can be produced in quantity relatively inexpensively (design costs and printing costs totaling around $5,000), and serves as a lead generator more than as a credibility piece.
Internet. A professionally designed website is also essential. In addition to franchise information, your website should be equipped with lead collection forms and, ideally, an autoresponder matrix that helps you sort the wheat from the chaff. And this site needs to be optimized for franchising. While websites are increasingly less expensive to create, you should still budget $10,000 to $15,000 for a really good one.
For franchisors looking for more aggressive growth, franchise sales videos are increasingly important in the sales process, as streaming video becomes a more integral part of the internet. Professionally produced videotapes promoting the franchise offering can generally be developed for between $15,000 and $25,000.
Marketing Budget. At least as important as the marketing materials will be your marketing budget. Depending on the size of the investment in a franchise opportunity, you should budget between $5,000 and $7,500 (and in some instances more) per franchise to be sold to a promotional budget. If you're planning to sell 20 franchises in your first year, an annual marketing budget of between $100,000 and $150,000 is not at all unrealistic. Of course, some of these funds will be recaptured as you begin to realize franchise fee income, but since it takes an average of 12 weeks to sell a franchise, as an aggressive franchisor, you should have at least have five to six months worth of advertising money--or about half your annual budget--on hand when you get started.
To optimize these expenditures, you should also invest in primary market research (to better understand your prospective franchisee) and in a first-rate marketing plan. While inappropriate for more conservative franchisors, these planning activities will add another $10,000 to $15,000 to the budget.
Hiring a Sales Force
But the single biggest investment you'll have in the development of an aggressive franchise company will be in your people.
Most companies getting into franchising for the first time do so by leveraging off of their existing staff. Often, the business founder acts as the primary franchise salesperson, with support from staff in the areas of operations and training. And while this works in most growth scenarios, the more aggressive the growth scenario, the sooner you should plan on bringing on incremental staff to fill key roles in the areas of franchise sales, franchise training and field support.
The first hire for the aggressive franchisor is generally the franchise salesperson. A proven franchise salesperson will generally command a compensation package in the low six figures, with at least some of this package being performance based. Top franchise sales pros can command twice the salary or more--but are generally worth their weight in gold. Again, you should expect the franchise salesperson to begin earning his keep by selling franchises relatively quickly (a good franchise salesperson should be able to sell 12 to 20 franchises per year), but you should anticipate the need to fund at least four to six months of their salary without any fee income. Add to this salary the fees you'll pay to an executive recruiter to locate this top talent (who will generally command a fee of 25 percent of first year's compensation), and you can probably budget $75,000 in personnel costs before selling the first franchise, should you go this route.
Other hiring generally comes later--after franchise sales have started and the royalty stream is established--but again, the more aggressive the growth, the earlier these hires need to take place.
Cash Flow Analysis
While this article provides an overview of the costs of getting into franchising, the best way to get a reasonable understanding of all these costs is to develop a cash flow analysis that accounts for all your hiring, marketing, legal and development needs, as well as for the inflow of franchise fees, royalties and other sources of income. While many factors will influence your ultimate cash need, a good rule of thumb is that an aggressive franchise program may require a cash flow budget of $250,000 to fund development costs and franchise growth until franchise sales begin "paying for" incremental personnel and advertising needs.
But remember, rules of thumb, like thumbs in a softball game, are often broken. Many franchisors have succeeded in growing significant franchise companies with far less--while others have failed at franchising after investing far more.
While it is important to be properly capitalized to franchise, it is important to remember that the costs of creating this franchise company, even in aggressive growth scenarios, is often less than the cost of starting just one more company operation. That investment in a franchise program can grow to be a franchisor with hundreds, or perhaps thousands, of franchised units, providing you with leverage not found in any other means of business expansion.
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