Buying a small business franchise? Pros and cons of franchising vs. starting a business

Buying a franchise vs. buying an existing business

More difficult than deciding whether to buy a franchise or start a business from scratch is whether to buy a franchise or buy an existing business. The difficulty lies in the fact that both the franchise and the existing business have many similarities, such as:

• Both a franchise and an existing business are (presumably) successful business concepts. If they weren't successful, you wouldn't be considering them now.
• Both will cause you to pay a premium for the successful business concept. A franchise may be more costly due to its previous track record of success.
• Both have name recognition. The existing business will have at least local name recognition while the franchise may have local and even national name recognition.
• Both may provide management support. Management support should be inherent in the franchise purchase. Management support generally isn't included in the purchase of an existing business but can be structured into the deal by retaining the seller to stay on as a consultant for a period of time.

Related article: Buying an existing small business

There are several advantages to purchasing a franchise over buying an existing business:

• Management support. One of the core concepts of a franchise is that the franchisor provides management support for the life of the franchise. Even if a seller has agreed to remain a consultant for an existing business, that consulting arrangement is for a limited period of time. After the consulting arrangement ends, the buyer is on his or her own.
• Greater exposure. A franchise will usually provide greater exposure to new customers through national advertising campaigns and name recognition.
• Costs shared. Expenses that apply to each franchise, such as advertising, may be pooled to take advantage of group discounts.
• Increased chance for success. Franchising succeeds only if the individual franchisees are successful. Thus, the franchises are packaged in a manner that will enable the franchisee to succeed. The franchises are usually based in whole or in part on previously successful franchise arrangements. In comparison, an existing business may not have any history other than its current one. Although an existing business is successful for the current owner, that success may not transfer over to another owner.
• Proven business methodology. A franchise can provide a training program to teach the franchisee about the business operation and industry, even if the franchisee has no prior experience.

When choosing between a franchise and an existing business, you must decide whether these extra benefits are worth the cost you'll have to pay for them.

Finding a franchise to buy

If you're considering buying a franchise, there are several places to look. If you have a pretty good idea which franchise you're interested in, the most obvious place to start is with the franchisor. The franchisor can give you all the information you'll need about purchasing a franchise.

An alternative that isn't so obvious but that can achieve the same result, and possibly at a savings, is to contact existing franchisees who are looking to sell their franchises. You may save money because you are not paying the franchisor a franchise fee since you are taking over an existing franchise.

You may, however, pay the equivalent of a franchise fee to the franchise seller if the seller is asking a premium for the franchise being sold. You can determine whether the premium is reasonable by comparing it to the cost of a franchise fee for a new franchise. A franchisor may be able to provide you with the name of an existing franchisee who is looking to sell his or her franchise. Finally, some franchisors may buy back and operate franchises from franchisees until they can find a suitable buyer.

Following is a list of places to look for franchises for sale:

• Franchise trade shows. These trade shows also provide an opportunity to talk to many franchisors and industry experts in one location. Often, the shows will have seminars to educate potential franchisees on what they can expect, and the advantages and disadvantages of being a franchisee. Among the larger conferences are the IFA Annual Convention, the Multi-Unit Franchising Conference, and the International Franchise Expo. There are also a number of organizations that hold regional conferences, such as The Franchise Shows produced by National Event Management.

• Online directories. There are a number of Internet sites that list franchises for sale.
• News publications. Most news publications, from large metropolitan publications to small local publications, have a classified ad section (online and/or print) in which businesses and franchises are listed for sale.
• Business brokers. Another route to finding a franchise is to go through a business broker. A business broker matches people who want to buy a franchise with people who are selling one. One of the benefits of using a broker is that the broker, at least a good one, will screen franchises that are for sale to determine if there are major problems and to make certain that the franchise being sold exists. However, the broker's fee to sell the franchise will probably result in a higher sales price.

Evaluating the franchisor

Buying a franchise, like making any other major purchase, should involve a thorough investigation. The time spent investigating the franchise, the industry, and the market will make you confident that your decision to buy (or not to buy) was the right decision.

What to look for. In general, a prospective franchisor should have an established reputation, sufficient capital, high-quality products or services, and satisfied franchisees.

A reference list of current and former franchisees should be available from the franchisor. (If a reference list isn't available, be cautious!) Try to determine whether the franchisor is attempting to expand the number of franchisees as quickly as possible (which may be at the expense of existing franchisees).

Try to answer as many of these questions as you can when considering a franchise:

• Is there a prototype location that is the basis for the franchising operation?
• Is the franchise too dependent on the founders of the franchise?
• Is there a strong management team of officers, directors, and consultants who understand the industry and the use of franchising as a means of expanding the business?
• Is there enough capital to support the franchising program and provide assistance to franchisees?
• Is there a recognized and distinctive trade identity that is a registered trademark? Does the franchise have a uniform trade appearance and overall image?
• Are there methods of operation and management that are proven? Have they been incorporated into an operating manual?
• Is there a comprehensive training program for franchisees?
• Is there support staff that can visit and assist franchisees?
• Is there support staff that can monitor and enforce quality control standards?
• Are there legal documents that reflect the franchise's history, strategy, and policies?
• Is there a strong market for the products or services that the franchise offers?
• Are there site selection criteria based on market studies and demographic reports?
• Does the franchisor have a record of refusing to renew the franchise if a new franchisee is particularly successful so it can take over the operation itself?

Keep in mind that this is not an exhaustive list of items to investigate. It's a starting point that identifies the main items to investigate.

Where to look. A franchisor must provide offering documents to prospective franchisees. According to federal law, the offering documents must be given to the prospective franchisee at the first meeting between the franchisor and the franchisee where the purchase of a franchise is seriously discussed. In any event, the offering documents must be given to the prospective franchisee no later than 10 days before the franchise agreement is signed or before any cash is paid.

The federal government, as well as most state governments, have rules and regulations regarding the content of the offering documents. The federal government approved a format, called the Uniform Franchise Offering Circular (UFOC), that has been adopted by virtually every state. It requires offering documents to be written in "plain English." The UFOC and other offering documents include the following information:

• The history of the franchise.
• The history of its owners.
• Procedures for terminating and renewing the franchise relationship.
• Quality controls.
• Fee structures.
• Financial statements.

Creating a franchise agreement

A franchise agreement is a contract between the franchisor and the franchisee. The agreement should balance the interests of the parties. However, in reality, if the franchise is a well-known organization like McDonald's Corporation, the franchise agreement is going to be more favorable to the franchisor. If the franchise is more obscure, you'll have more opportunity to negotiate favorable terms for yourself.

There really is no such thing as a standard franchise agreement because each contract will be drafted to suit the individual situation. Here is a partial list of items that entrepreneurs should look for and understand in a franchise agreement:

• Use of trademarks
• Franchise fees and other payments and costs
• Obligations and duties of the franchisee
• The territory refers to the designated area or region exclusively assigned to the franchisee.
• Restricted covenants encompass a range of actions that both current and former franchisees are obligated or prohibited from undertaking.
• Franchise agreements often feature an extensive guaranty section, aiming to ensure that the franchisee's new business covers reasonable expenses owed to the franchisor.
• The franchise agreement encompasses provisions regarding renewal rights as well as policies governing the transfer, termination, or cancellation of the franchisee's rights.

Making the franchise decision

Once you have found a franchise and have completed your investigation, all that's left is the final purchase decision. Here are a few suggestions for things you should think about before you make that final decision:

• Make absolutely sure that you've gathered all the information you can. Above all, don't rush into the decision until you've explored every avenue of the franchise.
• Make sure that the franchisor is reputable. When we hear "franchising," we often think "safe." But there are plenty of unscrupulous franchisors out there. Franchising is so popular these days not just because people are eager to buy, but also because people are so eager to sell them. There is a lot of money to be made by those who sell franchises.
• Make sure that you show the information you gathered to your lawyer and accountant. Ask them if they think buying the franchise is a good idea.
• Make sure that your decision is from the head as well as the heart. Don't buy a franchise, for example, just because you liked eating there once. Don't buy it unless you are reasonably sure that you can make some money from it.

Overall, franchising can be a good option for entrepreneurs who want to start a business with a proven track record of success. However, it is important to carefully research the franchise opportunity before making a decision.