This is the final in my three part series around the myths of buying a franchise. All this is based on real experience and I hope it helps folks out there who are looking to buy a franchise, or want to know more about the franchising business model. Thanks to the readers of this series for all your feedback and making it a popular search item.
~ Myths 1 to 3 can be found in part one of the series at “Top ten myths about buying a franchise – Part 1“
~ Myths 4 to 6 can be found in part two of the series at “Top ten myths about buying a franchise – Part 2“
Myth #7 – Long-term leases are great, because they protect me from substantial rent increases in the future – In an ideal world this is true. It is much easier to run you business if one of your major fixed costs is relatively static. Most leases have 3% increases build in per year. But, as I said in myth #4, most leases are – at a minimum – five years. And most leases for small players (new franchisees) are required to be personally guaranteed. Therefore, these long leases are more to protect the landlord than the franchisee. When things go bad, the only way to get out of the lease is to sell the store to someone else AND get the landlord to agree to release you from the personal guarantee – something that is not in there best interest. After all, they can take your house (assuming it has equity) if needed to payoff the five years worth of rent payments. So you could lose not just your business, but also your home.
Myth #8 – The franchise I am looking into has only a 4% failure rate – How could a smart guy like myself with a business degree and a reasonable amount of capital fail. After all, there is a 96% chance of success. As with Myth #5, this falls under the “Lies, Damn Lies, and Statistics” category. The reason the failure rate is so low for most franchisors is because they do not count distressed stores, which are sold at a loss. They only count stores that go completely out of business. For instance, my store was sold two times before the final owner went bankrupt. Therefore, although my store was bleeding cash, I was able it sell it for 50 cents on the dollar to a person that though they could turn it around. Likewise, that owner sold the store for 20 cents on the dollar (from my original investment). Therefore, from a failure rate perspective, my store was considered successful for almost four years, when in reality it was a failure from the beginning. So there are many stores that are sold to new owners for free (just take over the lease) and therefore are never reported as a failure.
Myth #9 – Be your own boss, control your destiny – Make no mistake, you are your own boss, you have all the responsibility and are accountable for your business. But you do not control your own destiny. The franchisor has a significant amount of control over how you run your operations and related expenses (as I eluded too in Myth #3). When the franchisor introduces a new product, you must buy it, whether your “personal” market will support it or not. If the franchisor decides that all stores need to have new wallpaper, guess what? You are buying wallpaper. Sometimes these upgrades are subsidized by the franchisor, but you will be paying for some if not all of it. The irony is the fact that many people have more “freedom” working in corporate American, than by owning a franchise. After all, if you don’t like the way your company is treating you, you leave. With a franchise, if you don’t like the way the franchisor is treating you, be ready to hire some expensive lawyers, because you are stuck.
Myth #10 – Increasing my net worth by building equity in the business – This is my favorite. I have an MBA degree from a top 30 university and I believed that buying a franchise was a good investment, not necessarily because of the cash flow, but because I thought the business would increase in value over time and become a valuable asset. Major mistake. Below are the three reasons why most franchises cannot be considered “appreciating assets” and thereby do not increase your net worth.
1. Most franchisees rent their locations. As the land and building increase in value, the build-out (the money you spent to “decorate” the inside of the location) drops in value. So as the landlord gets richer, you get poorer – asset wise. In addition, since most commercial leases are from 5 to 10 years, your ability to increase the value of the franchise has a definitive and limited timeline. As the lease term end date comes nearer, the value of the franchise will deteriorate because – assuming the franchise is making good money – the landlord will most likely increase your rent by a substantial figure when you sign a new lease, thus making the business less valuable.
2. In some ways, franchises are like cars, as soon as you drive them off the lot, they drop in value. The reason – why buy a used vehicle when you can a brand new one for just a little more. The same is true of franchises. After all, franchisors are in the business to expand the brand; that means they will authorize as many units as the market can bear – and a few more, just in case they guess low. Therefore, if you own a franchise in an average location, you are the equivalent of the used car. A buyer will look at the price of your unit and then the price of a new unit and determine that a new unit is a better buy, unless the “used” franchise is sold at a discount. Discounts don’t help when you are trying to increase your net worth.
3. Time is your enemy. As I said earlier, your lease affects the value of the business. Also, time in general is bad for franchises. The older your location gets, the more maintenance it will require. A one-year-old store is going to be in significantly better space than a 10-year-old store. We have all visited “older” McDonald’s and Wendy’s…they are looking pretty beat-up after all these years and eventually, someone is going to have to put a lot of money into a major remodeling job.
So there you have, my experiences distilled into 10 myths about franchising. I hope my findings and views help you in your decision making process. Buying a franchise is a viable option in the business world, but make sure you go in with your eyes open and not be fooled by all the marketing and statistical gimmicks that franchise companies try and sell you. Feel free to leave questions (via the comment option) on any of the 3 parts in this series.
This was a guest post by Tony Parker, an experienced investor across various asset classes and a past franchise owner.
Here are three recommended books on franchising worth reading if you want more detail on buying a franchise and the pro’s and con’s of doing so: