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The Franchise Play

10 things to know before buying a franchise

By Joseph Anthony

With many people living out their dreams running franchises, there's gotta be something right with the whole concept.

Literally hundreds of thousands of franchise operations exist, offering some people a chance to become millionaires buying and running them. Many are willing to pay significant sums to get into a franchise — I'm told it costs about a half-million dollars to open a McDonald's, which by some measures is the most successful franchise operation in history.

All that aside, buying a franchise is not an easy ticket to business success. For every success, there are many more failures, and the business landscape is littered with franchise fiascoes due to conflicts between franchisees and franchisors.

You have to practice the same due diligence as a franchise purchaser that you would with any major investment. In fact, in some ways you have to ask even more questions than you would if you were simply opening a business — because you have to understand issues involving the franchisor, as well as the usual risks involved in opening a business.

Here are 10 key questions I would ask before getting involved in a franchise operation.

1. What's my upfront cost going to be? This is the most obvious initial financial question. But immediate out-of-pocket costs are only one consideration in franchising.

2. What other fees should I plan on? You may be required to lease property or equipment from the franchisor. You may also have to
pay the franchisor a percentage of your annual sales. Those numbers must be cranked into your own equations when you're trying to figure out if a franchise deal makes sense.

3. How is the franchisor making money? Franchisors may make money by owning their own establishments, by providing services to franchisors, by simply collecting initial franchise fees from people like you or by some other combination. It's tough to make a blanket statement about whether one model is better than another, but surely you want to know where the franchisor's own interests lie.

4. What restrictions do I have on suppliers? Are you going to be required to purchase certain goods or services from particular vendors and/or from the franchisor? If certain purchases are required, are they going to cost you more than you would otherwise have to pay if there were no restriction on where you could buy them?

5. What kind of regional protection am I getting? Do you have any guarantees that the franchisor isn't going to sell other franchises or open up its own outlets in your geographic area? If so, how long are those guarantees good for?

6. What kind of empire-building opportunities do I have? The flip side of the previous question: Do you get first dibs on new franchises in or near the same area as your first franchise? Some of the most successful franchisees are those who own multiple outlets in the same area and are able to develop their own economies of scale.

7. How many franchisees fail in a year? You'd want to find out how many (or what percentage of) franchisees close their doors within the first
year or two years, and how many or what percentage of all franchisees close annually.

8. How many franchisees sell out in a year? A franchisee that gets out of the business by selling to someone else isn't necessarily included in the statistics of "failures." Indeed, he or she may be selling a successful venture. But you still need some idea of the turnover rate of franchisees.

9. What's the value of a re-sold franchise? Another way of looking at the prospects for franchisees is to look at what happens to those who sell their establishments. What did they get for the re-sold franchise relative to what they put into it? Was it a profitable investment, or were they simply looking to get out and cut their losses?

10. How do I get out of this deal, if necessary? Put another way, would you be allowed to sell your franchise? Can you sell to anyone, or do you have to deal with the franchisor? Would the company charge you something to sell your franchise or otherwise restrict your ability to pull out of the business?

Hopefully, you'll never find out what ultimately happens regarding that last question. But, as always, you need to be prepared for a worst-case scenario.

Joseph Anthony is a tax professional in Portland, Ore., who writes about finance and tax issues affecting small businesses Josephthetaxguy@hotmail.com

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