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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.

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One of the greatest advantages of franchising is that it allowsbusiness owners to expand their business using "OtherPeople's Money." Franchisees typically pay for all thestartup costs for each new unit. Real estate, build-out, inventoryand the negative cash flow of starting a franchise are all borne bythe franchisee. What's more, the franchisee typically pays thefranchisor an initial franchise fee that helps defray thefranchisor's cost of providing any initial assistance (such astraining, site selection assistance, initial support, etc.).

This system is extremely powerful, as it essentially frees thefranchisor from capital constraints--and allows the franchisor toopen franchises virtually "as fast as they can sellthem." 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 withmost new businesses, one of the most significant causes of failurefor new franchisors is undercapitalization.

One of the most important things to remember when making thedecision to franchise is that you are creating a new business--notsimply an extension of your existing business. Regardless of thebusiness you started in, you need to understand that franchising isthe business of selling and servicing franchisees. And your firstand most important priority must be to make your franchiseessuccessful.

While this new business allows you the ability to grow veryquickly in a highly leveraged way, you still need money to makemoney. So how much is enough?

The 31 Flavors of Franchising

Over the years, we have heard consultants and pundits float allkinds of estimates for the costs involved in franchising yourbusiness. Unfortunately, these estimates can vary considerably.This is due, at least in part, to the fact that franchising can bedone in a number of different ways. The bottom line: The mostimportant factor you should take into account when estimating thecosts of franchising is the aggressiveness of the desired expansionprogram.

Say, for example, you want to open one or two more units in yourlocal market by franchising. Perhaps you're looking to providean opportunity to your relatives or existing employees. Perhaps youonly have modest expansion goals.

In this scenario, you, as a prospective franchisor, need only tofigure out two basic costs: legal and quality control.

Legal Costs. You should retain an attorney who is afranchise specialist, as this area of the law is highly regulatedand complex. From a legal standpoint, an inexpensive attorneyspecializing in franchising might develop your basic legaldocuments (franchise agreement and Uniform Franchise OfferingCircular) and other related work (trademark protection, licenseagreements, etc.), for as little as $25,000. Depending on the statewhere you offer and open franchises, you may also need to complywith state registration laws that could cost several thousanddollars more.

You'll probably want to create a new corporation and need tohave a CPA conduct an opening audit of that company's balancesheet (up to three years of historical audits are required if theexisting company will be the franchisor, but most new franchisorsopt for the creation of a separate franchise entity for a varietyof reasons). And while certain states look askance at a weaklycapitalized franchisor, in nonregistration states, there are nolaws or guidelines governing initial capitalization, so a couplethousand dollars might cover the creation of this new entity.

Quality Control. Despite a desire for conservativegrowth, you still want to control quality--after all, you'vebuilt your name and reputation over the years with painstakingcare, and you won't want to take a chance on hurting yourexisting business by allowing the brand to suffer. Thus, you needto create an operations manual that will be the governing documentcontrolling quality within the system. Without this operationsmanual, you run significant risks relative to brand maintenance, asthe operations manual defines the standards of quality required ofthe franchisee, and is incorporated directly into the legalcontract between franchisor and franchisee.

While some entrepreneurs choose to develop their own operationsmanuals internally, this path carries certain risks. The operationsmanual, if properly crafted, not only controls quality, but alsolimits the franchisor's liability relative to the acts of thefranchisee and the franchisee's employees. To do that, theoperations manual needs to cover not only day-to-day operations,but a wide array of topics, in a way that does not createincremental liability through negligence or inadvertently creatingan agency relationship. But even if you were to create aprofessionally developed operations manual using a company such asmine, the costs of developing this manual would likely run under$25,000.

So to sell a few franchises locally, the documents needed to getstarted could be developed for about $50,000. But what if you havemore aggressive growth plans?

How High is "Up"?

If you're seeking to franchise aggressively, however, thesecosts can increase significantly.

Legal Costs. Legal expenses for a more aggressive rolloutmay include additional state registrations and more aggressiveand/or complex development contracts (area development contracts,area representative contracts, etc.). There are 14 registrationstates and a number of business opportunities states--each hasfranchise registration fees aggregating somewhere north of $6,000,not including the incremental legal costs your franchise attorneycharges you. All told, the legal costs for this more aggressivefranchise program can reach $50,000 or more.

Planning Costs and Consideration. A more aggressivegrowth strategy, by its very nature, also requires additionalplanning. While a company planning on conservative growth canprobably get away with a fairly informal planning process,aggressive growth dictates a thorough understanding of thecompetitive environment and the financial implications of eachbusiness decision. You need to build these financial and structuraldecisions on a solid understanding of the organization, and knowthe costs of building that organization in terms of people andcapital.

The aggressive franchisor must bear in mind that even seeminglysmall mistakes, when multiplied by hundreds of franchisees, can bethe difference between success and failure. Take royalties, forexample--while the difference between a 4 and 5 percent royalty mayseem small, that additional 1 percent could cost the franchisor$5,000 to $10,000 or more per franchise sold. That "1 percentmistake," when multiplied by 100 or more franchisees and byfive or more years on the contract, can easily mount into themillions.

Unfortunately, this more thorough planning process can be quiteexpensive. Depending on the nature and scope of research conductedon the market and on competitors, the amount and complexity offinancial planning, and various other factors, the costs of hiringa consultant to assist in the development of these plans couldrange between $25,000 and $35,000. In more complex situations, thisplanning can become significantly more expensive.

Quality Control. With more aggressive expansion plans,quality control will also become both more cumbersome and moreexpensive. With more franchisees going through the system, therewill be a need for a more formalized training program, and perhapstraining videotapes and other training tools. Again, this coulddouble the costs of your quality control.

Marketing Your New Franchise

Of course, the biggest difference between the conservative andthe aggressive growth franchisor is in the areas of franchise salesand marketing. While the conservative franchisor will be content tolet prospective franchisees come to him and operate in a reactivefashion, the aggressive franchisor will want to "make ithappen."

Brochures. Your marketing efforts start with thedevelopment of professionally designed materials. A full-sized,four-color brochure is virtually the cost of entry in modernfranchising. This brochure not only sells the franchise opportunityto the prospective franchisee--it also plays a key role indemonstrating the credibility of the franchise to key influencers:accountants, attorneys, bankers and spouses, who will play a keyrole in the franchise selection process. The design of a goodbrochure will cost between $7,000 and $10,000. Printing thisbrochure, depending on print process, paper quality, quantityprinted, and a variety of design specifications (full bleeds onpages, dye cuts, stapling, etc.), will cost another $8,000 to$10,000.

For companies with physical units, or companies that plan onusing a lot of direct mail or trade shows to promote theirfranchise, another great tool is the mini-brochure. This brochure,typically done in a two- or three-fold format, can be produced inquantity relatively inexpensively (design costs and printing coststotaling around $5,000), and serves as a lead generator more thanas a credibility piece.

Internet. A professionally designed website is alsoessential. In addition to franchise information, your websiteshould be equipped with lead collection forms and, ideally, anautoresponder matrix that helps you sort the wheat from the chaff.And this site needs to be optimized for franchising. While websitesare 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, franchisesales videos are increasingly important in the sales process, asstreaming video becomes a more integral part of the internet.Professionally produced videotapes promoting the franchise offeringcan generally be developed for between $15,000 and $25,000.

Marketing Budget. At least as important as the marketingmaterials will be your marketing budget. Depending on the size ofthe investment in a franchise opportunity, you should budgetbetween $5,000 and $7,500 (and in some instances more) perfranchise to be sold to a promotional budget. If you'replanning to sell 20 franchises in your first year, an annualmarketing budget of between $100,000 and $150,000 is not at allunrealistic. Of course, some of these funds will be recaptured asyou begin to realize franchise fee income, but since it takes anaverage of 12 weeks to sell a franchise, as an aggressivefranchisor, you should have at least have five to six months worthof advertising money--or about half your annual budget--on handwhen you get started.

To optimize these expenditures, you should also invest inprimary market research (to better understand your prospectivefranchisee) and in a first-rate marketing plan. While inappropriatefor more conservative franchisors, these planning activities willadd another $10,000 to $15,000 to the budget.

Hiring a Sales Force

But the single biggest investment you'll have in thedevelopment of an aggressive franchise company will be in yourpeople.

Most companies getting into franchising for the first time do soby leveraging off of their existing staff. Often, the businessfounder acts as the primary franchise salesperson, with supportfrom staff in the areas of operations and training. And while thisworks in most growth scenarios, the more aggressive the growthscenario, the sooner you should plan on bringing on incrementalstaff to fill key roles in the areas of franchise sales, franchisetraining and field support.

The first hire for the aggressive franchisor is generally thefranchise salesperson. A proven franchise salesperson willgenerally command a compensation package in the low six figures,with at least some of this package being performance based. Topfranchise sales pros can command twice the salary or more--but aregenerally worth their weight in gold. Again, you should expect thefranchise salesperson to begin earning his keep by sellingfranchises relatively quickly (a good franchise salesperson shouldbe able to sell 12 to 20 franchises per year), but you shouldanticipate the need to fund at least four to six months of theirsalary without any fee income. Add to this salary the feesyou'll pay to an executive recruiter to locate this top talent(who will generally command a fee of 25 percent of first year'scompensation), and you can probably budget $75,000 in personnelcosts before selling the first franchise, should you go thisroute.

Other hiring generally comes later--after franchise sales havestarted and the royalty stream is established--but again, the moreaggressive the growth, the earlier these hires need to takeplace.

Cash Flow Analysis

While this article provides an overview of the costs of gettinginto franchising, the best way to get a reasonable understanding ofall these costs is to develop a cash flow analysis that accountsfor all your hiring, marketing, legal and development needs, aswell as for the inflow of franchise fees, royalties and othersources of income. While many factors will influence your ultimatecash need, a good rule of thumb is that an aggressive franchiseprogram may require a cash flow budget of $250,000 to funddevelopment costs and franchise growth until franchise sales begin"paying for" incremental personnel and advertisingneeds.

But remember, rules of thumb, like thumbs in a softball game,are often broken. Many franchisors have succeeded in growingsignificant franchise companies with far less--while others havefailed 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 thisfranchise company, even in aggressive growth scenarios, is oftenless than the cost of starting just one more company operation.That investment in a franchise program can grow to be a franchisorwith hundreds, or perhaps thousands, of franchised units, providingyou with leverage not found in any other means of businessexpansion.

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