This article was last updated on October 14
Generally most Americans are not happy working for someone else or being in the corporate rat race. So the idea of being your own boss and controlling your destiny is very appealing. Besides some of the many “get rich quick” schemes on TV, there is one type of business that seems like an easy escape from the corporate (READ: Dilbert) world. It is to buy a franchise. Now there are many franchises available in a multitude of industries, but they all have two things in common. First, they project the image of financial freedom. Second, beyond a few boilerplate legal disclaimers – “By signing this contract, the franchisor is in no way guaranteeing the franchisee a profitable enterprise” – the franchise company (like a politician) only tells you the good news. So, to shed some light on franchising for readers of this site, I have complied a list of the top ten myths associated with buying a franchise. These items come from my own real life experiences when I owned a second-tier franchise for one year before selling it for a $170,000 loss. This very expensive lesson means that I know of what I cover here.
1. Buying into a brand – So you think that by purchasing a franchise, you are buying into a brand. And because the brand already has name recognition, you will only need to do a minimal amount of advertising. Basically – as the saying goes – “If you build it, they will come.” Well, unless you are in a fantastic location, you are competing against all the other franchisees/small shop owners in the neighborhood and people are NOT as loyal to any one brand as you think (with the exception of NASCAR fans!). So don’t get lulled into this sales pitch.
2. One-sided contract – The contract you sign with the franchisor is extremely one-sided. If anything goes wrong on your side, it is your problem. And if anything goes wrong on their side, they will take their time fixing it. Sure, they want you to succeed – more royalties for them – but you have no leverage over them if the ship starts to sink. And trust me, if you get too “agitated ” or “pushy”, their lawyers will pull out that contract and enforce it to the letter. And remember, you are losing money, so you cannot afford a decent lawyer to put up a good fight.
3. Turn Key Operation – So you think that buying a “Turn Key Operation” is going to compensate for your lack of industry experience and management skills – right? Well, like most things in life, this is a two-edged sword. The franchisor, in fact, will have policies and procedures that are documented to a shocking level of granularity, but these policies also leave very little room to maneuver when the money is NOT rolling in. Specifically, your fixed costs are in fact – fixed. And your variable costs are not as variable as you would think. For instance, with most franchises, you are required to purchase your products from the franchisor, one of its subsidiaries, or a preferred vendor. Therefore, you cannot go shopping around for the best price on the products you sell because the franchisor will not let you. Their argument is always the “quality factor”. How can they guarantee a consistent experience for all customers in all places if the franchisees are buying different products from different vendors? A reasonable assertion, but one that limits your ability to control one of your biggest costs.
Likewise, payroll is a variable cost, but most franchisors require that you have a minimum amount of staff on duty. A franchisee certainly does not want customers sitting in a long line because there is only one individual manning the store, but it is not very cost efficient if you have the same number of people on duty during busy periods as in slow periods (I am sure you have noticed this). Bottom line, “Turn Key” is great when you are making money but gives you very little flexibility when you need it the most, like when you need to cut costs.
Myth #4 – I will form a corporation to protect me – It is always a good idea to form a corporation to protect yourself from creditors if things go bad. In addition, corporate tax rates tend to be lower than personal income tax rates; therefore there are some savings involved with a incorporation. The problem is not with the corporation itself, but with specific creditors. The Small Business Administration (SBA) may back the bank loan you receive, but they are still going to require you to sign a personal guarantee. In addition, most landlords – especially those with sought after locations – will require a personal guarantee. Most commercial leases run – at a minimum – five years, therefore you are on the hook, personally, for five years worth of rent. When I sold my franchise for a massive loss to the new owner, the landlord required me to do two things:
> Agree to guarantee payment of the rent for the new owner for one year.
> Agree to pay all lawyers fees for the landlord and myself to transfer all the lease documents, etc.
This cost me about $7,000 in attorney’s fees. It was well worth it, but hurt nonetheless, given the loss I took on the sale.
Myth #5 – Franchisor will guarantee me a good Location, Location, Location – Most franchisor’s perform traffic/volume analysis on any location before you are allowed to begin negotiating the lease. This is supposedly for your benefit, but in reality, they are just statistics and do not guarantee a profitable volume. As Mark Twain said, “Lies, Damn Lies, and Statistics”. You can “spin” data to fit your objective. A great location is probably the most important decision – period. And yet like finding a good boyfriend/girlfriend, there are only so many great ones out there. And the competition among all types of businesses is fierce for these coveted locations.
Myth #6 – I will make lots of money (while being my own boss) – Most franchisees make between 50K to 100K per year and work long hours. Sure there are a few stores that produce six-figure incomes for the owner, but this is not the norm. After all, if a franchisee is making 200K at his store at the intersection of X and Y, then the franchise company will put another location a few miles away to take advantage of that volume. Franchisors would rather have two stores making 100K each, than one store making 200K. It gives them better control. They don’t like “powerful” franchisees; they are potential threats. The only way to make a lot of money with a franchise is to:
1) Buy a good franchise company – very few will be a runaway success;
2) Get in early;
3) Own multiple stores (four or more) in good locations
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.
- 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.
- 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.
- 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.